A Better Way to Gauge Profitability

Systematic ratio analysis using the advanced DuPont model.

August 2008
by David Burns, et al./Journal of Accountancy

Public accountants use ratios in nearly every service they offer to their clients. In the independent auditing arena, analytical procedures, which include ratio analysis, have effectively become a generally accepted auditing procedure since SAS 56 was issued in April 1988.

Ratios provide a concise and systematic way to organize the enormous quantity of data contained within financial statements into a framework that creates meaningful intelligence. Financial managers use ratios to benchmark their firm’s performance against that of their competitors and set goals for future performance. Financial advisers use ratios to identify under-priced or overpriced stocks and make recommendations to investors.

Return-on-equity (ROE) is the ratio most commonly used to analyze the profitability of a business. The “original” DuPont ROE model, which was created in 1919 by a finance executive at E.I. du Pont de Nemours & Co., breaks ROE into three fundamental drivers of accounting ROEs: net profit margin, asset utilization and financial leverage.

This has been excerpted from the Journal of Accountancy. Read the full article here.