From the course: Finance for Non-Financial Managers

What is the next step in the analysis?

From the course: Finance for Non-Financial Managers

Start my 1-month free trial

What is the next step in the analysis?

“

- We've used the DuPont Framework to break down return on equity into its component parts, profitability, efficiency, and leverage. Now, we know that Uncertain Company has lower profitability and lower efficiency than does Benchmark Company. We also know that Walmart has lower profitability and lower leverage than does Target. This is partially offset by Walmart's higher efficiency. Well, now what? Numbers can tell us what has happened, but additional analysis is needed to shed light on why these things have happened. The numbers seldom provide the answers to the questions. Instead, the numbers point you in the direction of the next question and the next question eventually leading you to talk with the right person in the organization who is responsible for the item of interest. To review, let's focus on our comparison of Uncertain Company and Benchmark Company, two companies in the same industry. First, we computed ROE for both companies and saw the ROE of Uncertain Company is significantly lower, 9.3% compared to 20.3% for Benchmark. Second. To gain insight into the cause of Uncertain's lower ROE, we use the DuPont framework to learn about Uncertain's profitability, efficiency, and leverage. This DuPont analysis showed us that Uncertain has lower profitability as evidenced by a profit margin of just 3.5% compared to the 6.2% profit margin of Benchmark. We also saw that Uncertain has lower efficiency. At uncertain, $1 in assets generates just a dollar and 38 cents in sales, whereas the same $1 in assets generates $1 in 70 cents in sales at Benchmark. Notice that we are systematically gaining deeper insight into the financial performance of Uncertain. Third, I alluded to an analysis of common size financial statements. We didn't do that analysis together, but we trust that my conclusions are correct. Such an analysis would show that the profitability problem at Uncertain is caused by excess wage expense and excess R&D expense. Also, the efficiency problem is caused by the fact that uncertain has too much money tied up in its accounts receivables, and it has purchased too much property, plant, and equipment for its level of sales. These first three steps are simply doing analysis with available information to lead us to the next clue. We drill down a little more and a little more. Okay, so what is step four? The numbers have taken us as far as they can. Now, we actually need to go out and talk to some people. For example, our analysis suggests that wage expense is too high. We now need to go to talk to the person in charge of compensation and ask why are wages so high? The answer may be the embarrassing fact that wages have spun out of control in the company and some corrective action is needed. Or it may be that these high wages are part of a strategic plan to hire the best and brightest people in a bid to improve operations going forward. We can't know the real reason for the high wages unless we have a discussion with an actual person. Again, the numbers can only take us so far. Our primary objective here has been to see that a careful analysis of the numbers can allow us to draw certain conclusions about the operations of a business. We have used financial statement information to do that, but you can do a similar analysis within a company using data that is only available internally. The point is this. A careful analysis of numbers across time can allow us to identify issues that deserve further attention through discussions with the relevant people. Turns out you don't need to be a numbers person to do that.

Contents