COMBINING FINANCIAL RATIOS
Up to this point we have considered financial ratios one at a time. However, there is a useful method for combining financial ratios known as Dupont1 analysis. To explain it, we first need to define some financial ratios, together with their abbreviations, as follows:
This equation says that Profit Margin × Asset Turnover × Leverage = Return on Equity.
Also, this equation provides a financial approach to business strategy. It recognizes that the ultimate goal of business strategy is to maximize stockholder value, that is, the market price of the common stock. This goal requires maximizing the return on common equity. The Dupont equation above breaks the return on common equity into its three component parts: Profit Margin (Net Income/Sales), Asset Turnover (Sales/Total Assets), and Leverage (Total Assets/Common Equity). If any one of these three ratios can be improved (without harm to either or both of the remaining two ratios), then the return on common equity will increase. A firm thus has specific strategic targets:
• Profit Margin improvement can be pursued in a number of ways. On the one hand, revenues might be increased or costs decreased by:
1. Raising prices perhaps by improving product quality or offering extra services. Makers of luxury cars have done this successfully by providing free roadside assistance and loaner cars when customer cars are being serviced.
2. Maintaining prices but reducing the quantity of product in the package. Candy bar manufacturers and other makers of packaged foods often use this method.
3. Initiating or increasing charges for ancillary goods or services. For example, banks have substantially increased their charges to stop checks and for checks written with insufficient funds. Distributors of computers and software have instituted fees for providing technical assistance on their help lines and for restocking returned items.
4. Improving the productivity and efficiency of operations.
5. Cutting costs in a variety of ways.
• Asset Turnover may be improved in ways such as:
1. Speeding up the collection of accounts receivable.
2. Increasing inventory turnover, perhaps by adopting “just in time” inventory methods.
3. Slowing down payments to suppliers, thus increasing accounts payable.
4. Reducing idle capacity of plant and equipment.
• Leverage may be increased, within prudent limits, by means such as:
1. Using long-term debt rather than equity to fund additions to plant, property, and equipment.
2. Repurchasing previously issued common stock in the open market.
The chief advantage of using the Dupont formula is to focus attention on specific initiatives that will improve return on equity by means of enhancing profit margins, increasing asset turnover, or employing greater financial leverage within prudent limits.
In addition to the Dupont formula, there is another way to combine financial ratios, one that serves another useful purpose—predicting solvency or bankruptcy for a given enterprise. It uses what is known as the z score.