COMM1140 Chap.4 Ratios, DuPont and Working Capital
Ratios, DuPont and Working Capital
Financial statement analysis compares accounting numbers across time, peers, targets and operating context. Ratios remove scale but do not explain themselves. This chapter selects measures by business question, calculates profitability, liquidity, activity and leverage consistently, and uses DuPont analysis to separate return on equity into margin, asset turnover and financial leverage.
Working-capital analysis follows inventory, receivables and payables through the cash-conversion cycle. Every interpretation identifies the mechanical driver, tests a business explanation and states the evidence needed before judgement.
What this chapter covers
- 01
Purpose and limitations of ratio analysis
- 02
Profitability and return measures
- 03
Liquidity and quick resources
- 04
Activity and turnover
- 05
DuPont decomposition
- 06
Cash-conversion cycle
Worked example · free
Explain a higher return on equity
- +1Use the DuPont relationship: return on equity equals margin multiplied by turnover and leverage.
- +1Calculate 0.07 × 1.6 × 2.2 = 0.2464, or 24.64%.
- +1Margin measures profit from sales, turnover measures sales generated by assets, and leverage measures assets supported per unit of equity.
- +1Do not label the result favourable without comparing risk, prior periods and peers.
Key terms
- Net margin
- Net income as a proportion of revenue, reflecting profit retained from each sales dollar after recognised costs.
- Asset turnover
- Revenue relative to average assets, used to assess how intensively the asset base generates sales.
- Financial leverage
- Average assets relative to average equity, showing the extent to which non-equity financing supports assets.
- Quick ratio
- Liquid current assets excluding inventory relative to current liabilities.
- Cash-conversion cycle
- Inventory days plus receivable days minus payable days, estimating the time operating cash remains committed.
Ratios, DuPont and Working Capital FAQ
Why can return on equity rise when operations do not improve?
Financial leverage can rise while margin and turnover remain unchanged. DuPont analysis exposes that financing effect, which may increase owners' return and fixed-claim risk together.
Is a shorter cash-conversion cycle always better?
It usually releases cash, but very low inventory can lose sales, aggressive collections can harm customers and delayed supplier payments can signal stress. Interpret components in operating context.
Why should average assets be used in return ratios?
Profit and revenue accumulate over a period while assets are measured at dates. An average better represents the resources available across that period than a single closing amount.
What makes a ratio conclusion credible?
Use consistent definitions, a relevant comparator, the statement line driving the movement and a limitation or corroborating source such as ageing, capacity or covenant data.
How should I investigate a DuPont movement?
Recalculate net margin, asset turnover and financial leverage from compatible inputs, then confirm that their product reconciles to return on equity. Identify which component moved most and connect it to a statement line or operating process. Margin can reflect prices, mix or costs; turnover can reflect sales growth, capacity or idle assets; leverage can magnify returns and fixed-claim risk.
Compare with a prior period or suitable peer and state what further evidence would distinguish competing explanations. The decomposition locates the question, while operating evidence supports the conclusion.
What can make working-capital days misleading?
Seasonality, acquisition timing, abnormal closing balances and inconsistent definitions can distort days measures. A year-end inventory balance after a peak sales period may not represent resources held throughout the year. Customer mix or disputed invoices can change receivable days without a general collection failure. Supplier terms can explain payable days more clearly than a broad liquidity label.
Use average balances when required, keep the sales or cost denominator consistent, inspect ageing and compare the same operating period. Then interpret the components before relying on the net cash-conversion cycle.
Why is a favourable ratio movement not enough for a recommendation?
A direction can have several causes with different consequences. Lower inventory days may reflect better planning or stock shortages; higher return on equity may reflect stronger operations or more leverage; a larger current ratio may reflect slow inventory rather than cash strength. State the numerical movement, identify its mechanical driver, propose plausible business causes and name evidence that would test them.
Include a relevant benchmark and downside risk. The recommendation should follow the mechanism and decision context instead of attaching a general adjective to the ratio.
Exam move
Group formulas by decision rather than memorising one long list. For each ratio, write the business question, numerator, denominator, period basis and likely driver. Rebuild DuPont from its components and confirm their product. Draw the cash-conversion cycle as a timeline and explain the sign of each day measure. Practise paired scenarios in which the same headline ratio changes for different reasons.
Finish every answer with a comparator, causal statement and next evidence check.
Working through Ratios, DuPont and Working Capital in COMM1140? Sia is AskSia’s AI Finance tutor — ask any COMM1140 Ratios, DuPont and Working Capital question and get a clear, step-by-step explanation grounded in how COMM1140 is taught and assessed. Read this chapter free, then take your hardest questions to Sia.
