Du pont Analysis, Cash flow, Capital Structure

Du Pont Analysis
Du Pont Analysis helps an analyst to understand the relation between two ratios and its impact on the return ratios. It helps to identify the factors which affects the return to the equity shareholders.

ROA = Net margin ratio * Asset Turnover ratio

NPAT = Total Assets

NPAT * Net Sales

Net Sales Total Assets

Such an analysis helps in understanding how return on total assets is affected by Net profit margin and Total assets turnover

ROE =

NP ratio * Total Asset turnover ratio * Equity multiplier NPAT * Sales * Total Assets Sales Total Assets Net worth

NPAT = Net worth

This analysis enables an analyst to understand whether the improvement in ROE is due to improved net margin or improved Asset turnover. It also helps the analyst to study the impact of leverage on ROE

ROE = ROA * Equity multiplier

NPAT Net worth

= NPAT * Total Assets

Total Assets Net worth

Equity multiplier depends upon the leverage of the company. A highly levered firm will have a high equity multiplier whereas a low levered firm will have a low equity multiplier.

Illustration Net Profit = Rs.34 lacs Sales = Rs.701 lacs Share capital = Rs.150 lacs Reserves & Surplus = 112 lacs Borrowed funds = Rs.212 lacs Total Assets ( Fixed + Current ) = Rs.474 lacs

Predicting financial distress through ratios Beaver and Altman employed statistical techniques to predict financial distress. Five financial ratios were able to discriminate between bankrupt and non bankrupt companies.
Zeta score model says ( Mfg companies ) Z = 1.2X1 + 1.4 X2 + 0.33X3 + 0.6X4 + 0.99 X5 X1 = working capital to total assets X2= cumulative retained earnings to total assets X3= EBIT to total assets X4= Market value of equity to book value of total liabilities X5= sales to total assets
A zeta score below 1.81 always signals financial distress and a zeta score over 2.99 conveys a financially healthy companies. Any score in between signals a possible financial distress.

Z score model B for non mfg. companies

W.Cap / Total Assets * 6.56 + Retained earnings / Total Assets * 3.26 + EBIT / Total Assets * 6.72 + Mkt. value of equity / Mkt. value of liabilities * 1.05

Score less 1.1 indicates bankruptcy Score more than 2.6 indicates financial soundness

Cash Flows and Capital Structure

Maximising returns to the shareholders is a prime concern for any company while deciding the capital structure. However availability of cash to service the debt is also very important since it may lead to cash insolvency of the company. Apart from coverage ratios which mainly concentrates on EBIT/EPS for deciding the optimum capital structure, the cash flow ability of the firm to service fixed charges is also to be analysed. So before working out the additional fixed charges , the firm should analyse the expected future cash flows because the fixed charges have to be met with cash. The inability of the company to meet these charges may lead to financial insolvency. If the company has stable future cash flows , the debt capacity will be higher. Hence analysts prefer to take EBITDA rather than EBIT for determining coverage ratios.

Credit rating

The impact of financing alternative on credit rating should also be considered. Rating agencies look upon a number of factors before assigning a grade. viz trends in liquidity ratios, debt, profitability and coverage, business risk past and present, cash flow ability to service debt. If a financing alternative lowers the companys security rating from an investment grade to speculative grade , then the security may become ineligible for Institutional investors.

Pecking order of financing Donaldson, Myers Internal financing of investment opportunities

avoids outside scrutiny no costs for use sudden changes in dividend can be avoided

Debt
Less intrusion Preferred by investors

Preference shares
contains some features of debt

Hybrid securities like convertible debentures Equity