and an interest rate of 9%. What would its net profit and ROE be in a bad year, a normal year, and
a good year?
19.4 RATIO ANALYSIS
Decomposition of ROE
To understand the factors affecting a firm’s ROE, including its trend over time and its per-
formance relative to competitors, analysts often “decompose” ROE into the product of a
series of ratios. Each component ratio is in itself meaningful, and the process serves to fo-
cus the analyst’s attention on the separate factors influencing performance. This kind of de-
composition of ROE is often called the Du Pont system.
One useful decomposition of ROE is
Net profits Pretax profits EBIT Sales Assets
Pretax Profits EBIT Sales Assets Equity
(1) (2) (3) (4) (5)
Table 19.6 shows all these ratios for Nodett and Somdett Corporations under the three dif-
ferent economic scenarios.
Let us first focus on factors 3 and 4. Notice that their product, EBIT/Assets, gives us the
similar to Table 19.6.
Turnover and Other Asset Utilization Ratios
It is often helpful in understanding a firm’s ratio of sales to assets to compute comparable
efficiency-of-utilization, or turnover, ratios for subcategories of assets. For example, fixed-
asset turnover would be
ROE 8.64% P/E 8 P/B .69
How does GI’s earnings yield in 2003 compare to the industry average?
Choosing a Benchmark
We have discussed how to calculate the principal financial ratios. To evaluate the perfor-
mance of a given firm, however, you need a benchmark to which you can compare its ratios.
One obvious benchmark is the ratio for the same company in earlier years. For example,
Figure 19.1 shows PepsiCo’s return on assets, profit margin, and asset turnover ratio for the
last few years. You can see there that ROA improved dramatically in 1999. This is attribut-
able largely to an improvement in profit margin, as well as to an increase in asset turnover.
It is also helpful to compare financial ratios to those of other firms in the same industry.
Financial ratios for industries are published by the U.S. Department of Commerce, Dun &
Bradstreet, Robert Morris Associates, and others. Table 19.10 contains some of the princi-
pal ratios for a wide range of U.S. industries. These can be useful benchmarks. For exam-
ple, if PepsiCo’s turnover ratio is less than that of Coke or other firms in the soft-drink
industry, one would want to know why.
19.5 ECONOMIC VALUE ADDED
One common use of financial ratios is to evaluate the performance of the firm. While it is
common to use profitability to measure that performance, profitability is really not
enough. A firm should be viewed as successful only if the return on its projects is better
Michelle Clayman, “In Search of Excellence: The Investor’s Viewpoint,” Financial Analysts Journal, May–June 1987.
Sales 6,679.3 4,537.0
Shareholders’ equity 2,233.3 2,347.3
What is the trend in IBX’s ROE, and how can you account for it in terms of tax burden, margin,
turnover, and financial leverage?
19.7 COMPARABILITY PROBLEMS
Financial statement analysis gives us a good amount of ammunition for evaluating a com-
pany’s performance and future prospects. But comparing financial results of different com-
panies is not so simple. There is more than one acceptable way to represent various items
of revenue and expense according to generally accepted accounting principles (GAAP).
This means two firms may have exactly the same economic income yet very different ac-