To understand the financial condition of the firm, it is important to get an overall sense of the firm’s performance. There are primarily two approaches to gaining this bird’s eye view of the firm’s finances. The first method provides a summary analysis of the firm’s financial ratios in order to highlight specific areas of responsibility. The DuPont method, on the other hand, attempts to find the areas that have resulted in the firm’s financial condition (Gitman, 2009).
An overall summary analysis examines ratios from the five key financial categories: liquidity, profitability, activity, debt, and market ratios. In terms of liquidity, Company X’s numbers may be below the generally accepted marks for these ratios, but they are above industry average. Therefore, we can conclude that Company X is maintaining an acceptable level of liquidity. Company X’s profitability ratios are also performing well when compared to the industry averages. Activity ratios illustrate how quickly certain accounts are converted to sales. There is a minor concern with how quickly Company X’s inventory is being turned over. It appears that Company X is keeping too much inventory on hand. In the coming year, the firm may need to re-evaluate production numbers in order to keep less inventory on hand. Company X’s debt ratios are also a cause for concern. The firm has relied heavily on borrowing to fund its projects. Most of the firm’s assets and equity are tied to incurred debt. Finally, the market ratios indicate investors are nervous about investing in the firm’s stock. Both the P/E and M/B ratios are down indicating the market is uncertain about the firm’s future performance.
A DuPont analysis focuses on two ratios: Return on Assets (ROA) and Return on Equity (ROE). ROA measures the return created by the firm’s assets without taking in account how those assets were funded. ROE measures the return enjoyed by the shareholders. Unlike ROA, it reflects how much debt is being used to finance the firm’s assets (Atkinson, Kaplan, Matsumura, & Young, 2007). ROA for Company X is higher than the industry average 21.5%. This means Company X is using its assets more efficiently. On the hand, ROE is also higher for Company X. This reflects the heavy debt financing that Company X is currently using. Much of this appears to be tied up in inventory.
Atkinson, A. A., Kaplan, R. S., Matsumura, E. M., & Young, S. M. (2007). Management accounting (5th ed.). Upper Saddle River, NJ: Pearson.
Gitman, L. J. (2009). Principles of managerial finance (12th ed.). Boston: Pearson.