This document discusses various techniques for financial statement analysis including common-size analysis, ratio analysis, and DuPont analysis. It provides an overview of each technique and explains that DuPont analysis decomposes return on equity (ROE) into its component parts to help evaluate the drivers of a company's profitability and determine areas for improvement. The document includes multiple excerpts and examples related to calculating and interpreting DuPont analysis.

1. 1
FIN410
Chapter 7:
Financial Analysis Techniques
(Lecture 5)
Standard Techniques of Financial
Statement Analysis
1. Common-size Analysis
1.1 Vertical Common-size Analysis
1.2 Horizontal Common-size Analysis
2. Ratio Analysis
2.1 Activity Ratios
2.2 Liquidity Ratios
2.3 Solvency Ratios
2.4 Profitability Ratios
2.5 Valuation Ratios
3. DuPont Analysis
Chapter 7; Lecture 1
Chapter 7; Lecture 2
Chapter 7; Lecture 3 and 4
Chapter 7; Lecture 5

2. 2
3. DuPont Analysis
• “ROE measures the return a company generates on its equity capital.
• To understand what drives a company’s ROE, a useful technique is to
decompose ROE into its component parts. (Decomposition of ROE is
sometimes referred to as DuPont analysis because it was developed
originally at that company.)”
• “Decomposing ROE involves expressing the basic ratio (i.e., net income
divided by average shareholders’ equity) as the product of component ratios.”
• “Because each of these component ratios is an indicator of a distinct aspect
of a company’s performance that affects ROE, the decomposition allows us
to evaluate how these different aspects of performance affected the
company’s profitability as measured by ROE.”
Excerpts from: (Robinson, T.R.; Henry, E.; Pirie, W.L.; Broihahn, M.A; 2015)
• “Decomposing ROE is useful in determining the reasons for
changes in ROE over time for a given company and for differences
in ROE for different companies in a given time period.”
• “The information gained can also be used by management to
determine which areas they should focus on to improve ROE.”
• “This decomposition will also show why a company’s overall
profitability, measured by ROE, is a function of its efficiency, operating
profitability, taxes, and use of financial leverage.”
• “DuPont analysis shows the relationship between the various
categories of ratios discussed in this chapter and how they all influence
the return to the investment of the owners.”
Excerpts from: (Robinson, T.R.; Henry, E.; Pirie, W.L.; Broihahn, M.A; 2015)

3. 3
Adapted from: (Robinson, T.R.; Henry, E.; Pirie, W.L.; Broihahn, M.A; 2015)
• “ROE is a function of ROA and Leverage; improving ROE requires improving either one of ratios.”
• “The interpretation on increasing ROA is straight forward; increase net income for each
dollar of assets to make more for shareholders.”
• “If the company does not borrow any money, i.e. if Leverage = 1, then ROE = ROA.”
• “Leverage should be increased up to the point cost of borrowing is less than marginal rate of
return on investment with borrowed money.
• If net income is growing at a slower rate than assets ROA will decrease resulting in decrease
in ROE.”
Excerpts from: (Robinson, T.R.; Henry, E.; Pirie, W.L.; Broihahn, M.A; 2015)

4. 4
Excerpts from: (Robinson, T.R.; Henry, E.; Pirie, W.L.; Broihahn, M.A; 2015)
• “To increase ROE we need to increase ROA. We can generate
more income for every dollar of asset invested either by increasing
revenue or controlling costs. “
• “ROA is a function of profitability (Net profit margin) and
efficiency (Total asset turnover).”
• We always want to make more revenue for any given level of
asset. No exception to that rule.
• But net income must grow at a higher rate than revenue.
Excerpts from: (Robinson, T.R.; Henry, E.; Pirie, W.L.; Broihahn, M.A; 2015)

5. 5
• “The first term on the right-hand side of this equation measures the effect
of taxes on ROE.”
• “A higher value for the tax burden implies that the company can keep
a higher percentage of its pretax profits, indicating a lower tax rate. A
decrease in the tax burden ratio implies the opposite (i.e., a higher tax rate
leaving the company with less of its pretax profits).”
Excerpts from: (Robinson, T.R.; Henry, E.; Pirie, W.L.; Broihahn, M.A; 2015)
• “The second term on the right-hand side captures the effect of interest on ROE.
Higher borrowing costs reduce ROE.”
• “The third term on the right-hand side captures the effect of operating margin (if
operating income is used in the numerator) or EBIT margin (if EBIT is used) on
ROE. In either case, this term primarily measures the effect
of operating profitability on ROE.”
Excerpts from: (Robinson, T.R.; Henry, E.; Pirie, W.L.; Broihahn, M.A; 2015)

6. 6
Excerpts
from:
(Robinson,
T.R.;
Henry,
E.;
Pirie,
W.L.;
Broihahn,
M.A;
2015)
See the solution in book. Expect such conceptual questions in exams.
Excerpts from: (Robinson, T.R.; Henry, E.; Pirie, W.L.; Broihahn, M.A; 2015)

7. 7
List of Examples to Practice from Chapter 7
• Example 1
• Example 2
• Example 3
• Example 5
• Example 7
• Example 8
• Example 9
• Example 10
• Example 11
• Example 12
• Example 13
• Example 14
• Example 15
• Example 16
• Example 9
• Example 10
• Example 11
• Example 12
• Example 13
• Example 14
• Example 15
• Example 16
Plus, practice the MCQs that appear as ‘Problems’ at the end of the
chapter. Focus on MCQs on topics discussed in class.