Reading ratios together
When studying ratios, analysts often synthesise by reading several together to find extra insight. If sales are growing but the collection period is increasing alongside, the company is probably being very lenient with credit terms to boost sales. One popular framework that synthesises ratios is DuPont analysis, which breaks return on equity into components to show how each factor contributes, and doubles as a diagnostic study of why ROE rose or fell.
ROE = Net profit / Equity = (Net profit / Sales) x (Sales / Assets) x (Assets / Equity)
- Three factors: net profit margin, asset turnover ratio, and leverage or the equity multiplier.
- Sales and assets cancel across the fractions, leaving net profit over equity.
- ROE can go up if profit margin increases, if asset turnover (efficiency) goes up, or because of higher leverage.
An ROE increase from higher margin or higher efficiency is certainly a reason to cheer. An increase from higher leverage need not be, because higher leverage also brings higher risk.
HighLevCo and LowLevCo
| HighLevCo | LowLevCo | |
|---|---|---|
| Revenue | 12,000.0 | 11,800.0 |
| Net profit | 2,400.0 | 2,620.0 |
| Assets | 5,200.0 | 5,000.0 |
| Equity | 2,600.0 | 5,000.0 |
| Liability | 2,600.0 | none |
| ROE | 92.3% | 52.4% |
| Asset turnover | 2.3x | 2.4x |
| Net profit margin | 20% | 22% |
| Assets / equity | 2.0x | 1.0x |
The two companies are of similar size, and HighLevCo's far higher ROE makes it look like the better performer. Breaking ROE into three parts gives a different picture: LowLevCo does marginally better on asset turnover and reasonably better on profit margin, and its ROE is lower only because of low leverage. LowLevCo is the better operator, and its lower debt also reduces the risk it faces.
In the syllabus's two-company case study, Company A has higher ROE than Company B. A's net profit margin is higher, its asset turnover (the activity ratio) is higher, and its financial leverage is lower. The factors that favourably contributed to the higher ROE are therefore the higher margin and the higher activity ratio; lower leverage worked against it.
The exam offers answer choices that credit higher leverage as a favourable contributor, or that pick the higher-ROE company as the better operator. Check the three components first. A company whose entire ROE edge comes from the equity multiplier is not operating better; it is borrowing more.
- Analysts synthesise ratios by reading them together: sales growing while the collection period lengthens probably means lenient credit terms used to boost sales.
- DuPont analysis breaks ROE into three factors: net profit margin (net profit / sales), asset turnover (sales / assets) and leverage or the equity multiplier (assets / equity). Their product is net profit / equity. It also works as a diagnostic tool for a rise or fall in ROE.
- ROE rises if margin improves, if asset turnover (efficiency) improves, or if leverage increases. The first two are reasons to cheer; the third need not be, because higher leverage brings higher risk.
- HighLevCo (revenue 12,000, net profit 2,400, assets 5,200, equity 2,600, liabilities 2,600) shows ROE 92.3% against LowLevCo's 52.4% (revenue 11,800, net profit 2,620, assets 5,000, equity 5,000, no liabilities). Yet LowLevCo has marginally better asset turnover (2.4x versus 2.3x) and reasonably better margin (22% versus 20%); its lower ROE comes only from an equity multiplier of 1.0x versus 2.0x. LowLevCo is the better operator and carries less risk.