10-05-2014, 12:14 PM
How to analyse profitability: DuPont system, EBITDA and earnings quality
How to analyse profitability.pdf (Size: 485.9 KB / Downloads: 240)
INTRODUCTION
The DuPont system enables one to examine a firm’s financial
statements to determine what, if anything, is causing its Return on
Investment or Return on Equity (ROE) to fall short of expectations.
This is accomplished by breaking these returns into three component
parts: Profit margin, asset turnover, and return on assets. Only
when one of these three is identified as an area of weakness can
management take appropriate steps towards improvement.
EBITDA Analysis
EBITDA refers to “earnings before deduction of interest expense,
income taxes, depreciation and amortisation.” This number is often
used in ratio analyses prepared by stock analysts. By using this
number the analyst attempts to reduce the effect of outside influences
(such as interest expense), the impact of timing (depreciation), and
the impact of authorities on profit.
Earnings Quality
The quality of a company’s earnings depends upon two things. The
first is the company’s perceived ability to continue earning profits at
current levels or better. When we believe that it can continue at this
rate, then we argue that earnings quality is good. If we doubt that it
can continue earning at this rate, then we argue that earnings quality
is poor. The key word here is “perception” because the measurement
of earnings quality is judgemental and the analyst must rely on
several things to form an opinion. The second aspect of earnings
quality is the relation of earnings to cash flow. While earnings and
cash flow are not the same thing, if they have no relation with each
other then we argue that earnings quality is poor.