272 SECTION 1 The Role of Accounting as an Information System In equation form, the DuPont framework looks like this: Return on equity 5 Profit margin 3 Asset turnover 3 Equity multiplier ___N_e_t_ i _n_c_o_m_e_____________Net income Total sales 5 3 Avg. total equity Total sales Avg. total assets _______ _______ Avg. total equity ______ __ ____ __ Avg. total assets 3 Notice that total sales and average total assets appear in the numerator of one ratio and the denominator of another, so they cancel to yield net income 4 average total equity, or ROE. We have already seen that ROA is determined by profit margin and asset turnover, so another way to compute ROE is by multiplying ROA by the equity multiplier: Return on equity 5 Return on assets 3 Equity multiplier _ __N_e_t_ i _n_c_o_m_e___Net income 5 Avg. total equity Avg. total assets _______ _______ Avg. total equity ______ __ ____ __ Avg. total assets 3 We can see from this equation that an equity multiplier of greater than 1 will produce a return on equity that is higher than the return on assets. However, as with all ratio analysis, there are trade-offs. If leverage is too high, creditors become concerned about the potential for default on the company’s debt and require higher interest rates. Because interest is recognized as an expense, net income is reduced, so at some point the benefits of a higher equity multiplier are offset by a lower profit margin. Part of the challenge of managing a company is to identify the combination of profitability, activity, and leverage that produces the highest return for equity holders. Additional Consideration Sometimes when return on equity is calculated, shareholders’ equity is viewed more narrowly to include only common shareholders. In that case, preferred stock is excluded from the denominator, and preferred dividends are deducted from net income in the numerator. The resulting rate of return on common shareholders’ equity focuses on profits generated on resources provided by common shareholders. Illustration 5–25 provides a recap of the ratios we have discussed. Illustration 5–25 Summary of Profitability Analysis Ratios Activity ratios Asset turnover 5 _____N_e _t_ s_ a_le_s_ ____ Average total assets Receivables turnover 5 _________ _ N__e_t _s_al_e_s_ _ ________ Average accounts receivable (net) Average collection period 5 ______ ____3_6 5_ _________ Receivables turnover ratio Cost of goods sold ________ _______Average inventory Inventory turnover 5 Average days in inventory 5 ______ ___3_6 5_ ________ Inventory turnover ratio Profitability ratios Profit margin on sales 5 _N_e_t_ i_n _c_o_m_e_ Net sales Return on assets 5 ____N_e_t_ i_n_ c_o_m_e_ ___ Average total assets Return on shareholders’ equity 5 _______N_ _ e_t _in_c_o_m__e _ ______ Average shareholders’ equity Leverage ratio Equity multiplier 5 Average total assets ________ ________Average total equity
Spiceland_Inter_Accounting8e_Ch05
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