Question

1. Discuss the key uses and the key abuses of financial statements and ratios. Provide a practical example.

2. Define the Dupont system, why is it important?

Please detailed brief answers 400 words at least for each question

Answer 1

1. Key uses and abuses of financial statement and ratios

Advantages

a. Financial statement provide information on performance of the company (Profitability, liquidity, etc. ) for past and present. Ratio analysis helps company to identify trends based on past data as well as comparison with previous years.

b. Ratio analysis identifies strength and weakness of the company. It will help company determine which matrix of performance requires improvement

c. Financial statement follow GAAP of that particular country thus inter company comparison can be made properly to determine company with fundamentally better prospect

d. Most important benefit is that it helps investors to make decision on if they should invest in shares of the company. At the same time helps company to take business decision looking at financial performance matrix.

For practical example- Refer Dupont ratio analysis in Q2

Abuses

a. Financial statement depends too much on historical values. Even ratio analysis provides trends only but doesn't take into account inflation, legal, political condition.

b. Financial statement takes only items which can be quantitatively measured. Thus qualitative factors are completely ignored.

c. If the GAAP followed are different then comparison inter company becomes hard.

d. Financial statement can be cooked up by the company to show fancy picture of business to investors.

Practice example-

In financial statement qualitative things like brand value cannot be recorded

Financial statement was cooked up in Enron scam and Arthur and Anderson was involved in fudging the books

2. Dupont system

Dupont analysis is one of the most practically used ratio tool to understand which performance matrix of the company requires improvement.

Normally ratio is used to identify one performance matrix. Say, gross profit ratio to evaluate direct trading profitability of company or net working capital ratio to evaluateworking capital requirement of the company, etc. However it provides evaluation on standalone matrix of performance.

Dupont ratio netted off would provide return on equity ratio.

ROE= PAT/ Equity ( This is after net off ). Now let me elobarte

ROE= PAT/Sales * Sales/Total assets * Total Assets/Equity

Now in the above ratio-

a. PAT/Sales evaluates operational efficiency leading to profit

b. Sales/Asset evaluates if assets are used optimally

c. Asset/Equity evaluates if company is leveraged well (i.e capital structure is good/not)

As per Dupont analysis these are the 3 major performance matrix.

Example company has ROE of 5% (5 PAT /100 Equity ). This might look like company's operational efficiency is low and thus leading to loss. This might not be true. This is where Dupont helps in evaluation.

ROE = PAT/Sales * Sales/Asset * Asset/Equity

5% = 5/20 * 20/400 * 400/100

5% = 25% * 0.05 * 4

Thus our evaluation is that

PAT/sales is 25% so operational efficiency is good ( Our earlier standalone analysis is wrong )

Sales/Asset is 0.05 so assets are highly underutilized. This is the major problem with company and not operationally efficiency.

Asset/Equity is 4, this means company has not been levered well and capital structure needs some adjustments.