Advanced Use of Accounting Ratios

There are plenty of courses that make more advanced use of accounting ratios. You can find them in the business school. Often what they do is pull apart ratios to find out why one firm's performance is different than another.

We don't really look into those in this class, but to give you the flavor, we will introduce a single example, DuPont Analysis.

DuPont starts with the return on common equity and decomposes it into three parts.

ROE=(Profit Margin)(Asset Turnover)(1 - Debt Ratio)= Net profit/common equity = (Net Profit/Total Revenue)(Total Revenue/Total Assets)(Total Assets/Total Equity)

If you go through the definitions, you will see that the denominator of the profit margin is the same as the numerator of asset turnover and so on. After all those cancellations, you end up with the return on common equity.

This allows you to see the effects of the individual components on the return on common equity. For example, an increase in the profit margin will increase the return on common assets, as will a decrease in the debt ratio (note the negative sign).

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