CHAPTER TWO

IFRS- BASED FINANCIAL STATEMENT ANALYSIS AND FINANCIAL

PLANNING

2. ANALYSIS OF FINANCIAL STATEMENTS

The primary goal of financial management is to maximize the stock price.

However, accounting data do influence stock prices, and to understand why
a company is performing the way it is and to forecast where it is heading,
one needs to evaluate the accounting information reported in the financial
statements. This chapter shows how financial statements are used by
management to improve performance, by lenders to evaluate the likelihood
of collecting on loans and by stockholders to forecast earnings, dividends,
and stock prices.

If management is to maximize a firm’s value, it must take advantage of the

firm’s strengths and correct its weaknesses. Financial statement analysis
involve

(1) Comparing firm’s performance with that of other firms in the same
industry and (2) evaluating trends in the firm’s financial position over time.
This study helps management identify deficiencies and then take action to
improve performance. In this chapter, we focus on how financial managers
(and investors) evaluate a firm’s current financial position. Then, in the
remaining chapters, we examine the types of actions management can take
to improve future performance and thus increase its stock price.

This section should, for the most part, be a review of concepts you learned in
accounting. However, accounting focuses on how financial statements are
made, whereas our focus is on how they are used by management to
improve the firm’s performance and by investors when they set values on
the firm’s stock and bonds.

Financial Analysis
Financial statements report both on a firm’s financial position at a point in
time and on its operations over some past periods. However, the real value
of financial statements lies in the fact that they can be used to help predict
future earnings and dividends. From an investor’s stand point, predicting the
future is what financial statement analysis is all about, while from
management stand point, financial statement analysis is useful both to help

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anticipate future conditions and, more important, as a starting point for
planning actions that will improve the firm’s future performance.

Financial ratios are designed to help one evaluate a financial statement. For
example, consider the following data:
Debt Interest
Firm A $5,248,760 $419,900
Firm B 52,647,980 3,948,600

Which company is stronger? The burden of these debts, and the companies’
ability to repay them, can best be evaluated by:
(1) comparing each firm’s debt to its assets and
(2) comparing the interest it must pay to the income it has available
for
payments of interest.
Such comparisons are made by ratio analysis.

Financial analysis is a process of identifying the financial strength and

weakness of the firm by properly establishing relationships between the
items of the balance sheet and income statement. The users of financial
analysis are numerous in numbers and being different in their point of
emphasis.

Trade creditors are interested in the firm’s ability to meet their claims over
a very short period of time and therefore their main concern is liquidity
position. Suppliers of long-term debt, on other hand, are concerned with
the firm’s long-term solvency and survival. They basically analyze the firm’s
profitability over time, its ability to generate cash to pay interest and repay
principal and the relationship between various sources of funds (capital
structure relationships). Long term creditors do analyze the historical
financial statements, but they place more emphasis on the firm’s projected,
or pro forma, financial statements to make analysis about its future solvency
and profitability.

Investors are more concerned about the firm’s earnings. They concentrate
on the analysis of the firm’s financial structure to the extent it influences the
firm’s present and future profitability. They are also interested in the firm’s
financial structure to the extent it influences the firm’s earning ability and
risk. Management is interested in every aspect of the financial analysis. It is
their overall responsibility to see that the resources of the firm are used
most efficiently and effectively and that firm’s financial condition is sound.

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2.1 Purposes of Financial Analysis

Ratios are highly important profit tools in financial analysis that help financial
analysts implement plans that improve profitability, liquidity, financial
structure, reordering, leverage, and interest coverage. Although ratios report
mostly on past performances, they can be predictive too, and provide lead
indications of potential problem areas.

Ratio analysis is primarily used to compare a company’s financial figures

over a period of time, a method sometimes called trend analysis. Through
trend analysis, one can identify trends, good and bad, and adjust business
practices accordingly. He/she can also see how ratios stack up against other
businesses, both in and out of your industry.

There are several considerations you must be aware of when comparing

ratios from one financial period to another or when comparing the financial
ratios of two or more companies.
# If you are making a comparative analysis of a company’s financial
statements
over a certain period of time, make an appropriate allowance for any
changes in
accounting policies that occurred during the same time span.
# When comparing one business with others in the same industry, allow
for any
material d/ces in accounting policies between the company & industry
norms.

# When comparing ratios from various fiscal periods or companies,

inquire
about the types of accounting policies used. Different accounting
methods can
result in a wide variety of reported figures.
# Determine whether ratios were calculated before or after adjustments
were
made to the balance sheet or income statement, such as non-
recurring items
and inventory or pro forma adjustments. In many cases, these
adjustments
can significantly affect the ratios.
# Carefully examine any departures from industry norms.

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2.2 Types of Analysis (Approaches)

Any successful business owner will constantly evaluate the performance of

his or her company, comparing it with the company’s historical figures, with
its industry competitors, and even with successful businesses from other
industries. To complete a thorough examination of company’s effectiveness,
however, we need to look at more than just easily attainable numbers like
sales, profits, and total assets. It is a must to be able reading between the
lines of financial statements and make the seemingly inconsequential
numbers accessible and comprehensible.

In this regard comparative ratio analysis helps to identify and quantify

company’s strengths and weaknesses, evaluate its financial position, and
understand the risks that may be taken. As with any other form of analysis,
comparative ratio techniques are not definitive and their results shouldn’t be
viewed as gospel. Many off-the-balance-sheet factors can play a role in the
success or failure of a company. But, when used in concert with various
other business evaluation processes, comparative ratios are invaluable.

a) Time series analysis

This is the easiest way of evaluating the performance of a firm by comparing

its present ratios with the past ratios. It gives indication of the direction of
change and reflects whether financial performance has improved,
deteriorated or remained constant over time. It is important not only to
determine the change but also why the change has happened.

b) Cross sectional analysis

It is comparing ratios of the one firm with selected firms in the industry at
the same point in time, basically with competitors having similar operations.
This kind of comparison indicates the relative financial position and
performance of the firm.

c) Industrial analysis

This analysis compares its ratio with average ratios of the industry of which
the firm is member. It helps to ascertain the financial standing and capability
of the firm vis-à-vis other firms in the industry. The practical difficulty
involved in this analysis is the following:
1. It is difficult to get average ratios for the industry.

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 2. Even if the averages are available, they are averages of the ratios of
strong
and weak firms and might be meaningless especially if firms within
the
same industry widely differ in their accounting policies and practices.

d) Pro forma analysis

This is using future ratios as the standard of comparison. These future ratios
can be developed from the projected or pro forma financial statement. The
comparison of current or past ratios with future ratio show the firm’s relative
strength and weaknesses in the past and the future. If the future ratios
indicate weak financial position, corrective actions should be initiated.

2.4 RATIO ANALYSIS

A. SHORT-TERM SOLVENCY, OR LIQUIDITY MEASURES (LIQUIDITY
RATIOS)

Liquidity Ratios: are used to determine a company’s ability to meet its

short-term debt obligations with current assets without losing its value.

Solvency : refers to the ability of a company to generate a stream of cash

inflows sufficient to maintain its productive capacity and still meet the
interest and principal payment on its long-term debt.

A liquid asset is one that trades in an active market and hence can be
quickly converted to cash at the going market price, and a firm’s “liquidity
position” deals with this question: Will the firm be able to payoff its debts as
they come due over the next year or so? A full liquidity analysis requires the
use of cash budgets, but by relating the amount of cash and other current
assets to current obligations, ratio analysis provides a quick, easy-to-use
measure of liquidity. Three commonly used liquidity ratios are discussed in
this section.

i) The Current Ratio: Ability to Meet Short-term Obligations

The current ratio is calculated by dividing current assets by current liabilities:

Current ratio = Current Assets

Current Liabilities

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Current assets normally include cash, marketable securities, accounts
receivable, and inventories. Current liabilities consist of accounts payable,
notes payable, current maturities of long term debt, accrued taxes, and
other accrued expenses (principally wages).

1:1 current ratio, for example, means; the company has $1 in current assets
to cover each $1 in current liabilities. Look for a current ratio above 1:1 and
as close to 2:1 as possible. When the current ratio significantly high it would
indicate also that the firm is inefficient in using its cash and other short term
assets. Generally short term creditors prefer higher current ratios because it
assures them liquidity. It has to be noted that however a lower current ratio
might not be a bad sign for a company with a large reserve of untapped
borrowing power.

If a company is getting into financial difficulty, it begins paying its bills

(accounts payable) more slowly, borrowing from its bank, and so on. If
current liabilities are rising faster than current assets, the current ratio will
fall, and could spell trouble. Because the current ratio provides the best
single indicator of the extent to which the claims of short-term creditors are
covered by assets that are expected to be converted to cash quickly, it is the
most commonly used measure of short-term solvency.

The following computation gives Allied’s current ratio:

Current ratio = Current Assets = 4125 = 1.64 times

Current Liabilities 2512.5
Industry average = 2.3 times

Allied’s current ratio is well below the average for its industry, 2.3, so its
liquidity position is relatively weak. Still, since current assets are scheduled
to be converted to cash in the near future, it is highly probable that they
could be liquidated at close to their stated value.

It should be noted at this point that an industry average is not a magic

number that all firms should strive to maintain – in fact, some very well
managed firms would be above the average while other good firms will be
below it. However, if a firm’s ratios are far removed from the average for its
industry, an analyst should be concerned about why this variance occurs.
Thus, a deviation from the industry average should signal the analyst (or
management) to check further.

The problem with the current ratio is that it ignores timing of cash received
and paid out. For example, if all the bills are due this week, and inventory is
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the only current asset, but won’t be sold until the end of the month, the
current ratio tells very little about the company’s ability to survive.

ii) Quick (Acid Test) Ratio

Quick ratio is the ratio between all assets quickly convertible into cash and
all current liabilities. Specifically excludes inventory. Also known as the “acid
test.” This ratio specifies whether your current assets that could be quickly
converted into cash are sufficient to cover current liabilities. Thus, the quick
ratio is a more conservative measure of liquidity. A firm that had additional
sufficient quick assets available to creditors was believed to be in sound
financial condition. The quick ratio assumes that all assets are of equal
liquidity. Receivables are one step closer to liquidity than inventory.

Quick (acid test) = Current Assets – Inventories

ratio Current Liabilities

Inventories are typically the least liquid of a firm’s current assets; hence they
are the assets on which losses are most likely to occur in the event of
liquidation. Therefore, a measure of the firm’s ability to payoff short-term
obligation without relying on the sale of inventories is important.

Quick ratio indicates the extent to which you could pay current liabilities
without relying on the sale of inventory – how quickly you can pay your bills.
Generally, a ratio of 1:1 is good and indicates you don’t have to rely on the
sale of inventory to pay the bills.

Computation quick ratio for Allied Company follows:

Quick ratio = CAs – Inv. = 4125 – 2225 = 0.76 times

CL s 2512.5
Industry average = 1.2 times.

The industry average quick ratio is 1.2, so Allied’s 0.76 ratio is low in
comparison with other firms in its industry. Still, if the accounts receivable
can be collected, the company can payoff its current liabilities without
having to liquidate its inventory.

Although a little better than the current ratio, the quick ratio still ignores
timing of receipts and payments.

The crucial assumption behind this ratio is that a firm’s accounts receivable
will be converted into cash with the normal collection period with little
shrinkage or within the period of time for which credit was initially granted.

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An analyst who doubts the liquidity of a firm’s receivables can prepare an
aging schedule and adjust the ratio downward if a significant percentage of a
firm’s receivables are long past due and have not been written off as losses.
The adjustment process is to reduce accounts outstanding over the normal
collection period. This is possible only for internal analyst because the data
required to prepare an aging schedule are primarily for internal analyst.

iii) Absolute Liquidity Ratio

This ratio is sometimes referred as cash ratio. Since cash is the most liquid
assets it is employed for examining the liquidity of the firm. It is a
subsequent innovation in ratio analyst; the Absolute Liquidity Ratio
eliminates any unknown surrounding receivables. The Absolute Liquidity
Ratio any tests short – term liquidity in terms of cash and marketable
securities.

Trade investment or marketable securities are equivalent to cash and

therefore, they might be included in the computation of cash ratio.

Absolute Liquidity = Cash

Ratio Current Liabilities
Or
Absolute Liquidity = Cash + Marketable Securities
Ratio Current Liabilities

Allied’s Cash ratio is calculated as :

Cash Ratio = Cash + MS = 140 + 0 = 0.056 times
CL S 2512.5

B. LONG TERM SOLVENCY (DEBT MANAGEMENT) RATIOS

Long-term solvency ratios are intended to address the firm’s long-term

ability to meet its obligation or its financial leverage. For this reasons are
sometimes called as financial leverage ratios or leverage ratios. Whenever a
firm finances a portion of assets with any type of fixed charge financing such
as debt, preferred stock or lease the firm is said to be using financial
leverage. This group of ratios calculates the proportionate contributions of
owners and creditors to a business, sometimes a point of contention
between the two parties.

i) Total Debt to Total Assets: How the Firm is Financed?

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The ratio of total debt to total assets, generally called the debt ratio,
measures the percentage of funds provided by creditors:

Debt Ratio = Total Debt

Total Assets
Total debt includes both current liabilities and long-term debt. Creditors
prefer low debt ratios because the lower the ratio, the greater the cushion
against creditors’ losses in the event of liquidation. Stockholders, on the
other hand, may want more leverage because it magnifies expected
earnings.

Allied Company’s debt ratio equals 54% as computed below:

Debt Ratio = Total Debt = 3862.5 = 54%
Total Assets 7105
Industry average = 40%

Allied’s debt ratio is 54%, which means that its creditors have supplied more
than half of the total financing. There are a variety of factors determine a
company’s optimal debt ratio. Nevertheless, the fact that Allied’s debt ratio
exceeds the industry average raises a red fag and may make it costly for
Allied to borrow additional funds without first raising more equity capital.
Creditors may be reluctant to lend the firm more money, and management
would probably be subjecting the firm to the risk of bankruptcy if it sought to
increase the debt ratio any further by borrowing additional funds.

ii) Times Interest Earned: Ability to Pay Interest

The times-interest-earned (TIE) ratio, also called interest coverage ratio, is

determined by dividing earnings before interest and taxes by the interest
charges

TIE Ratio = EBIT

Interest Charges

The TIE ratio measures the extent to which operating income can decline
before the firm is unable to meet its annual interest costs. Failure to meet
this obligation can bring legal action by the firm’s creditors, possibly
resulting in bankruptcy. Note that earnings before interest and taxes, rather
than net income, are used in the numerator. Because interest is paid with
pre-tax dollars, the firm’s ability to pay current interest is not affected by
taxes.

Allied’s interest is covered 4.67 times:

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 TIE Ratio = EBIT = 980 = 4.67 times
Interest Charges 210
Industry average = 6 times.

Since the industry average is 6 times, Allied is covering its interest charges
by a relatively low margin of safety. Thus, the TIE ratio reinforces the
conclusion from our analysis of the debt ratio that Allied would face
difficulties if it attempted to borrow additional funds.

C. ASSET MANAGEMENT RATIOS

Asset management ratios, also called activity ratios or turnover ratios,

measure how effectively the firm is managing and utilizing its assets. They
indicate how much a firm has invested in a particular type of asset relative to
the revenue the asset is producing.

These ratios are designed to answer this question: Does the total amount of
each type of assets as reported on the balance sheet seem reasonable, too
high, or too low in view of current and projected sales levels?

When they acquire assets, Allied and other companies must borrow or obtain
capital from other sources. If a firm has too many assets, its cost of capital
will be too high; hence its profits will be depressed. On the other hand, if
assets are too low, profitable sales will be lost. Ratios that analyze the
different types of assets are described in this section.

i) The Inventory Turnover Ratio: Evaluating Inventories.

Inventory turnover ratio shows how rapidly the inventory is turning into
receivables through sales. It is given by the following formula.

Inventory turnover = Cost of goods sold

ratio (ITR) Average inventory

Average inventory can be computed in one of the following two ways:

NB. Beginning inventory plus ending inventory divided by two, or if sales are too
seasonal, the summation of twelve-month balances divided by twelve.

If cost of goods sold figure is not available it can be computed as:

ITR = Sales
Avg. Inventories

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A problem arises in calculating and analyzing the inventory turnover ratio in
this second way. Sales are stated at market prices, so if inventories are
carried at cost, as they generally are, the calculated turnover overstates the
true turnover ratio. Therefore, it would be more appropriate to use cost of
goods sold in place of sales in the formula’s numerator.

In the absence of data as to inventory balances at different time periods, it is

also possible to take end of year inventory balance. We will use this
approach to compute inventory turnover ratio for Allied Co. the problem in
using this approach will be dealt shortly.

Generally speaking high inventory turnover ratio is indicative of good

inventory management. A low inventory turnover level implies excessive
inventory level than warranted by production or sales, or a slow-moving or
obsolete inventory. A high level of sluggish inventory amounts unnecessary
ties up funds, reduced profit ad increased costs. A high inventory turnover
also might be the result of very low level of inventory, which results stock
outs.

For Allied Co. its inventory turnover ratio can be computed as follows:
ITO Ratio = Sales = 8250 = 3.7 times
Avg. inventory 2225

Industry average = 6 times.

As a rough approximation, each item of Allied’s inventory is sold out and

restocked, or “turned over,” 3.7 times per year. This is much lower than the
industry average of 6 times. This suggests that Allied is holding too much
inventory. Excess inventory, off course, unproductive, and it represents an
investment with a low or zero rate of return. Allied’s low inventory turnover
ratio also makes us question the current ratio. With such a low turnover, we
must wonder whether the firm is actually holding obsolete goods not worth
their stated value.

ii) The Days Sales Outstanding: Evaluating Receivables

Days sales outstanding (DSO), also called the “average collection period
(ACP)”, is used to appraise accounts receivable. It is average number of days
an account receivables remain outstanding. It tells us how many days of
sales are tied up in receivables. The greater the ratio than the average of the
industry mean the firm allocated a greater proportion of total resources to
receivable than the average firm in the industry.

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Thus, the DSO represents the average length of time that the firm must wait
after making a sale before receiving cash, which is the average collection
period.

DSO = Receivables = Receivables

Avg. sales per day Annual sales / 360

Allied has 77 days sales outstanding, well above the 63-days industry
average
DSO = Receivables = 1760 = 76.80 days
Avg. sales per day 8250/360

The DSO can also be evaluated by comparison with the terms on which the
firm sells its goods. For example, Allied’s sales terms call for payment within
60 days, so the fact that 77 days’ sales, not 60 days’, are outstanding
indicates that customers, on the average, are not paying their bills on time.
This deprives Allied of funds that it could use to invest in productive assets.
Moreover, in some instances the fact that a customer is paying late may
signal that the customer is in financial trouble, in which case Allied may have
a hard time ever collecting the receivable.

iii) The Fixed Assets Turnover Ratio: Evaluating fixed assets.

This ratio indicates the extent to which a firm is using existing property,
plant, and equipment to generate sales. It is the ratio of sales to net fixed
assets.

Fixed Assets Turnover = Sales

Ratio (FAT) Net Fixed Assets

Allied Company’s fixed assets turnover ratio follows:

FAT Ratio = Sales = 8250 = 2.76
times
Net Fixed Assets 2980
Industry average = 2.76 times.

Allied’s ratio of 2.76 times is equal to the industry average, indicating that
the firm is using its fixed assets about as intensively as are other firms in its
industry. Therefore, Allied seems to have about the right amount of fixed
assets, in relation to other firms.

iv) The Total Assets Turnover Ratio: Evaluating total assets.

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The final asset management ratio, the total assets turnover ratio, measures
the turnover of all the firm’s assets. It indicates how effectively firm uses its
total resources to generate sales and is a summary measure influenced by
each of the asset management ratio discussed previously.

It is calculated by dividing sales by total assets:

Total Asset Turnover = Sales
Ratio (TAT) Total Assets

Allied Company’s TAT ratio is given as:

TAT Ratio = Sales = 8250 = 1.16 times
Total Assets 7105
Industry average = 1.4 times.

Allied’s ratio is somewhat below the industry average, indicating that the
company is not generating a sufficient volume of business given its total
asset investment. Sales should be increased, some assets should be
disposed of, or a combination of these steps should be taken.

D. PROFITABILITY RATIOS

Profitability is the net result of a number of policies and decisions. The ratios
examined thus far provide useful clues as to the effectiveness of a firm’s
operations, but the profitability ratios show the combined effects of liquidity,
asset management, and debt on operating results.

i) Profit Margin on Sales Ratio

The profit margin on sales, calculated by dividing net income by sales, gives
the profit per dollar of sales:

Net income available to

Profit margin = common stockholders
on sale ratio Sales

Allied’s profit margin on sales follows:

Profit margin = 410 = 4.97%
on sales ratio 8250

Industry average = 6%

Allied’s profit margin is below the industry average of 6%. This sub-par result
occurs because costs are too high. High costs, in turn, generally occur

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because of inefficient operations. However, Allied’s low profit margin is also a
result of its heavy use of debt. Recall that net income is income after
interest. Therefore, if two firms have identical operations in the sense that
their sales, operating costs, and EBIT are the same, but if one firm uses more
debt than the other, it will have higher interest charges. Those interest
charges will pull net income down, and since sales are constant, the result
will be a relatively low profit margin.

In such a case, the low profit margin would not indicate an operating
problem, just a difference in financing strategies. Thus, the firm with the low
profit margin might end up with a higher rate of return on its stockholders’
investment due to its use of financial leverage. We will see exactly how profit
margins and the use of debt interact to affect stockholder returns shortly,
when we examine the Du Pont model.

ii) Basic Earning Power (BEP)

BEP ratio indicates the ability of the firm’s assets to generate operating
income. The basic earning power (BEP) ratio is calculated by dividing
earnings before interest and taxes (EBIT) by total assets.

BEP = EBIT
Total Assets

BEP for Allied Co. can be computed as follows:

BEP = EBIT = 980 = 13.79%

Total Assets 7105

Industry Average = 17.2%

This ratio shows the earning power of the firm’s assets, before the influances
of taxes and leverage, and it is useful for comparing firms with different tax
situations and different degrees of financial leverage. Because of its low
turnover ratios and low profit margin on sales, Allied is not getting as high a
return on its assets as other firms in the industry.

iii) Return on Total Assets (ROA)

The ratio of net income to total assets measures the return on total asset
(ROA)
after interest and taxes:

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 Net income available to
ROA = common stockholders
Total Assets

ROA for Allied Company follows:

Net income available to
ROA = common stockholders = 410 = 5.77%
Total Assets 7105
Industry Average = 9%

Allied’s 5.77% return is well below the 9% average for the industry. This low
return results from (1) the company’s low basic earning power plus (2) high
interest costs resulting from its above-average use of debt, both of which
cause its net income to be relatively low.

iv) Return on Common Equity (ROE)

Ultimately, the most important, or “bottom line,” accounting ratio is the ratio
of net income to common equity, which measures the return on common
equity (ROE).

Net income available to

ROE = common stockholders
Common Equity

ROE for Allied Company is given below:

Net income available to

ROE = common stockholders = 410 = 12.64%
Common Equity 3242.5
Industry average = 15%
Stockholders invest to get a return on their money, and this ratio tells how
well they are doing in an accounting sense. Allied’s 12.64% return is below
the 15% industry average, but not as far below as the return on total assets.
This is somewhat better result is due to the company’s greater use of debt, a
point that is analyzed in detail later in the chapter.

E. MARKET VALUE RATIOS

A final group of ratios, the market value ratios, relates the firm’s stock price
to its earnings, cash flow, and book value per share. These ratios give
management an indication of what investors think of the company’s past
performance and future prospects. If the liquidity, asset management, debt

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management, and profitability ratios all look good, then the market value
ratios will be high, and the stock price will probably be as high as can be
expected.

i) Price/Earnings Ratio (P/E)

The price/earnings (P/E) ratio shows how much investors are willing to pay
per dollar of reported profits.
P/E ratio = Price per share
Earnings per share (EPS)
Allied’s stock sells for $47.5, so with an EPS of 3.94 its P/E ratio is 12.05:
P/E ratio = Price per share = $47.5 = 12.05 times
EPS $3.94
Industry average = 13.5 times.
P/E ratios are higher for firms with strong growth prospects, other things held
constant. But they are lower for riskier firms. Since Allied’s P/E ratio is below
the average for other firms in the industry, this suggests that the company is
regarded as being somewhat riskier than most, as having poorer growth
prospects, or both.

ii) Market/Book Ratio

The ratio of a stock’s market price to its book value gives another indication
of how investors regard the company. Companies with relatively high rates
of return on equity generally sell at higher multiples of book value than those
with low returns.

Market/Book = Market price per share

(M/B) ratio Book value per share

First, we find Allied’s book value per share:

Book value per share = Common equity
Shares outstanding
= 3242.5 = $31.17
104
Now we divide the market price per share by the book value to get a M/B
ratio of 1.52 times.
Market/Book = Market price per share
(M/B) ratio Book value per share
= $47.5 = 1.52 times
$31.17
Industry average = 1.7 times.

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Investors are willing to pay less for a dollar of Allied’s book value than other
firms in the industry.

THE DUPONT CHART AND EQUATION: Tying the ratios together.

Du Pont chart is a chart designed to show the relationships among return on

investment, asset turnover, the profit margin, and leverage.

The profit times the total assets turnover is called the Du Pont equation. Du
Pont equation is a formula, which shows that the rate of return on assets can
be found as the product of the profit margin times the total assets turnover.
Du Pont equation gives the rate of return on assets (ROA):
ROA = Profit margin x Total assets turnover
= Net Income = Sales
Sales Total Assets
= 4.97% X 1.16 = 5.765%

Allied made 4.97% on each dollar of sales, and assets were “turned over”
1.16 times during the year. Therefore, the company earned a return of
5.76% on its assets.

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