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# lecture 11 - Business Finance Lecture 11 Review of the...

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59 Business Finance Lecture 11 Review of the Previous Lecture Ratio Analysis Short-term solvency, or liquidity, ratios Current ratio Acid Test (Quick) ratio Cash ratio Long-term solvency, or financial leverage, ratios Total Debt ratio Interest Coverage ratio Cash Coverage Ratio Asset management, or turnover, ratios Inventory Turnover & Days’ Sale in Inventory Receivables Turnover & Average Collection Period Payables Turnover Total Assets Turnover & Capital Intensity Ratio Review of the Previous Lecture Ratio Analysis Profitability ratios Profit Margin Return on Assets Return on Equity Market value ratios Price-Earnings Ratio Market-to-Book Ratio Du Pont Identity Topics under Discussion The Du Pont Identity (cont.) Income Distribution Dividend Payout Ratio Retention Ratio Internal and Sustainable Growth Determinants of Growth Using Financial Statement Information Internal Uses External Uses Benchmarking

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60 The Du Pont Identity The difference between the two profitability measures, ROA and ROE, is the use of debt financing , or financial leverage. The relationship between these measure can be illustrated by decomposing ROE into its component parts. The Du Pont Identity Recall, Net Income ROE = -------------------- Total Equity Multiplying it by Assets / Assets (without changing anything) Net Income Net Income Assets ROE = -------------------- = ---------------- x ----------- Total Equity Total Equity Assets Net Income Assets = ---------------- x ---------------- Assets Total Equity The Du Pont Identity Net Income Assets ROE = ---------------- x ---------------- Assets Total Equity So, we have expressed ROE as a product of two other ratios – ROA and the equity multiplier ROE = ROA x Equity multiplier = ROA x (1 + Debt-Equity ratio) The Du Pont Identity Looking back at A2Z: Debt-Equity Ratio = 0.39 ROA = 10.12% while ROE calculated previously = 14% Now, using the decomposition method: ROE = 10.12% x 1.39 = 14% The Du Pont Identity We can further decompose ROE by multiplying the top and bottom by total sale: Sales Net Income Assets ROE = -------- x ---------------- x ---------------- Sales Assets Total Equity
61 Rearranging a bit, Net Income Sales Assets ROE = --------------- x ----------- x ---------------- Sales Assets Total Equity Return on Assets = Profit x Total Assets x Equity Margin Turnover Multiplier The Du Pont Identity ROE = Profit x Total Assets x Equity Margin Turnover

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lecture 11 - Business Finance Lecture 11 Review of the...

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