The Du Pont Company of US pioneered a system of financial analysis which has received widespread recognition. As a useful tool for financial analysis, it has been adopted by many firms in some form or the other. The earning power, represented by return on capital employed, shows the combined effect of the net profit margin and the capital turnover.
A change in any of these ratios will change the firm’s earning power. These two ratios are affected by many factors. Any change in these factors will bring a change in these two ratios. The usefulness of the Du Pont type of analysis lies in the fact that it presents the over-all picture of the performance of a firm as also enables the management to identify the factors which have a bearing on profitability.
The two components of this ratio, namely, the profit margin and the investment turnover ratio individually do not give an over-all view as the former ignores the profitability of investments while the latter fails to consider the profitability on sales.
A financial ratio is the principal tool for analysis of financial statements. It helps to ascertain the financial condition of a firm. Financial ratios seem to have predictive ability, particularly in signalling business strengths and weaknesses of a firm.
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The most important financial ratios may be divided into four types:
(a) LIQUIDITY refers to the ability of a firm to meet its obligations in the short run, usually one year. Liquidity ratios are calculated by establishing relationships between current assets and current liabilities. For examples, Current Ratios, Liquid Ratios, Fund Flow Ratios etc.
(b) FINANCIAL LEVERAGE refers to the use of debt finance. To judge the long term financial position of a firm, leverage or capital structure ratios are calculated. These ratios indicate the funds provided by owners and creditors. That is, these ratios measure the proportion of outsiders capital in financing the firm’s assets and establishing the relationships between borrowed capital and equity capital. For example, Debt-Equity Ratios, Capital-Equity Ratios, Interest Coverage Ratios etc.
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(c) TURNOVER RATIOS, also referred to as activity ratios or asset management ratios measure how efficiently the assets are employed by the firm. These ratios are calculated by establishing relationship between sales and assets. For examples, Stock Turnover, Debtors Turnover, Fixed Asset Turnover etc.
(d) PROFITABILITY RATIOS measure the overall performance of Business – profit margin ratios and rate of return ratios. Profit margin ratios show the relationship between profit and sales, for examples, Gross Profit Margin, Net Profit Margin etc. Rate of Return Ratios reflect the relationship between profit and investment, for examples, Return on Investment, Return on Equity etc.