CHAPTER 19
Financial Statement Analysis
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McGraw-Hill/Irwin Copyright © 2011 by The McGraw-Hill Companies, Inc. All rights reserved.
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Financial Leverage and ROE
Debt
ROE = (1 − t )ROA + (ROA − r )
Equity
• If there is no debt or ROA = r, ROE will
simply equal ROA(1 - t).
• If ROA > r, the firm earns more than it pays
out to creditors and ROE increases.
• If ROA < r, ROE will decline as a function
of the debt-to-equity ratio.
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Table 19.5 Impact of Financial
Leverage on ROE
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Decomposition of ROE
DuPont Method
Net Profit Pretax Profit EBIT Sales Assets
ROE = x x x x
Pretax Profit EBIT Sales Assets Equity
(1) x (2) x (3) x (4) x (5)
Tax Interest
x x Margin x Turnover x Leverage
Burden Burden
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Decomposition of ROE
ROA=EBIT/Sales X Sales/Assets
= margin X turnover
• Margin and turnover are unaffected by leverage.
• ROA reflects soundness of firm’s operations, regardless
of how they are financed.
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Decomposition of ROE
ROE=Tax burden X ROA X Compound leverage factor
• Tax burden is not affected by leverage.
• Compound leverage factor= Interest burden X Leverage
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Table 19.6 Ratio Decomposition Analysis for Nodett and
Somdett
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Choosing a Benchmark
• Compare the company’s ratios across time.
• Compare ratios of firms in the same industry.
• Cross-industry comparisons can be misleading.
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Table 19.7 Differences between Profit Margin and Asset
Turnover across Industries
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Table 19.9 Summary of Key Financial
Ratios
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