Chapter 6 of 8
Ratios and DuPont: diagnose before ranking
Use liquidity, leverage, profitability and return ratios with matched numerators, averages and economic context.
In this chapter
A ratio is a compressed question #
Current ratio compares current assets with current liabilities but says little about the quality or timing of each balance. Debt/equity depends on the debt and equity definitions. Interest coverage depends on the chosen earnings measure.
Write the formula beside every number. Industry practice differs, and a ratio suitable for a manufacturer may be misleading for a bank. Negative or near-zero denominators can make a ranking meaningless.
Separate operating return from financing effect #
ROE typically compares profit attributable to ordinary owners with average corresponding equity. ROCE and ROIC have multiple conventions; declare the operating earnings, tax and capital definitions.
Using closing equity instead of average equity can distort a year with a large issue or buyback. Compare return with the risk and funding required to earn it, not only with another firm’s headline percentage.
Use DuPont to ask why ROE changed #
A simple three-part identity expresses ROE as net margin × asset turnover × equity multiplier when definitions align. Margin measures profit per revenue, turnover revenue per assets and multiplier assets per equity.
Higher leverage can lift ROE without improving the operating business. The identity diagnoses arithmetic; it does not explain the cause by itself. Trace changes in the statements and check whether a smaller equity denominator drives the result.
Compare peers after normalising the perimeter #
Match periods, business mix, accounting policies, lease treatment and unusual items. Use consistent average balances. A cheap-looking multiple or high ratio can reflect a different growth or risk profile.
Do not mechanically take the industry average as a target. Explain which peer is relevant and which differences remain unresolved. A ratio sheet should lead to a business question, not end the research.
Hypothetical worked example
A fictional DuPont comparison
Net margin 10%, asset turnover 1.5 times and equity multiplier 2 produce ROE of 30% under consistent definitions. With unchanged operations and multiplier 3, ROE becomes 45%.
The higher ROE came from leverage, not improved margin or turnover. Debt service and downside risk must be reviewed before calling the second case better.
Common mistakes
- Ranking incompatible ratio definitions.
- Treating leverage-driven ROE as pure business improvement.
- Using a negative denominator as a normal valuation comparison.
ROE rises only because the equity multiplier rises. What should you investigate?
Make this chapter useful
Can you defend the reasoning?
Before moving on, answer the self-check in your own words and write why each alternative fails. Use the worked example to test that explanation. Then apply it in the module research task; keep the assumptions and the evidence that could change your answer.
Desk assignment
What to submit
Build a peer table with formulas, normalisations, DuPont attribution and three questions the ratios cannot answer.
Use the research ledger for dated evidence, or the module workbooks for calculations. Separate observations, assumptions and interpretation.
Sources and further reading
- NISM: Research Analyst learning topics (scope reference; independent lessons) ↗
- NSE: company integrated financial filings ↗
Further-reading references from the curriculum source list. Contract sizes, expiry calendars, settlement references, margin parameters and tax treatment can change; verify the current operative documents for the actual product. Worked figures are illustrative, not current quotes.
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