Advanced Financial Analysis: DuPont, Working Capital and Earnings Quality
Where a high return on equity really comes from, how much cash is tied up in working capital and how to spot dressed-up profits – DuPont analysis, the cash conversion cycle and accruals step by step.
Key takeaways
- DuPont analysis splits return on equity into margin × asset turnover × financial leverage. The same return can come from very differently risky sources.
- Working capital is money tied up in inventory and receivables. The cash conversion cycle measures how many days it is tied up.
- Growth costs cash. A long cash conversion cycle can push a profitable company into a cash crunch.
- Earnings quality shows when you compare profits with cash flow. If profits run well above operating cash flow for years, be careful.
- “Adjusted” figures are not standardised. Always check what was stripped out – and whether it was really one-off.
In the lesson on the income statement and cash flow you learned to read a balance sheet and calculate the key ratios. Professionals go a step further: they ask not only how high a return is, but where it comes from, how much cash the business ties up and how real the profits are. This lesson answers exactly those three questions.
DuPont: where does return on equity come from?
Return on equity relates net income to shareholders’ equity. A figure of 20% sounds good – but says nothing about how it arises. As early as the 1920s the chemicals group DuPont developed a breakdown into three factors:
The three factors are called net margin (how profitable is each dollar of revenue?), asset turnover (how much revenue does each dollar of assets generate?) and financial leverage (how much of the assets are financed with debt?). Multiplied together they give exactly the return on equity.
| Firm A: software | Firm B: wholesale | |
|---|---|---|
| Net margin | 20% | 2% |
| Asset turnover | 0.5 | 2.5 |
| Financial leverage | 2 | 4 |
| Return on equity | 20% | 20% |
Both companies earn 20% on their equity. But firm B lives on high volume at a wafer-thin margin and lots of debt. If its costs rise by just one percentage point of revenue, its profit halves. If interest rates rise, leverage eats the rest. Firm A, by contrast, has pricing power and little debt – the same return, a completely different risk.
Working capital: money stuck in the business
A company buys raw materials, stores them, processes them, sells the goods on credit and then waits for the customer to pay. During all this time money is tied up. Conversely, suppliers give the company payment terms of their own. The difference is called working capital:
The cash conversion cycle
More telling than the absolute amount is the question: how many days pass between paying the supplier and receiving cash from the customer? This span is called the cash conversion cycle (CCC). It is made up of three measures:
- Days sales outstanding (DSO): receivables ÷ revenue × 365 – how long customers take to pay on average.
- Days inventory outstanding (DIO): inventory ÷ cost of goods sold × 365 – how long goods sit in stock.
- Days payables outstanding (DPO): trade payables ÷ cost of goods sold × 365 – how long the company makes its suppliers wait.
Some business models achieve a negative cash conversion cycle: customers pay immediately, goods turn over quickly, suppliers wait a long time. Supermarkets and online retailers such as Amazon partly finance their growth with their suppliers’ money this way. The faster they grow, the more cash flows in.
Earnings quality: how real is the profit?
Profit is a calculated figure full of assumptions and judgement calls: when is revenue booked? Over how many years are assets depreciated? How large are provisions? Cash flow, on the other hand, is hard to fake – the money is in the account or it isn’t. The difference between the two is called accruals.
A company with $100m net income but only $40m operating cash flow and $1bn in total assets has an accruals ratio of 6%. That is high. In 1996 the researcher Richard Sloan showed that stocks with high accruals performed markedly worse on average in the following years – investors had overlooked the weak earnings quality.
Typical warning signs you can find in annual reports:
- Receivables grow faster than revenue – customers aren’t paying, or revenue is being pulled forward.
- Inventory grows faster than revenue – the goods are harder to sell than claimed.
- Costs are capitalised instead of expensed – for example development or sales costs, which are then depreciated over years.
- Depreciation periods are lengthened – this lowers annual depreciation and raises profit without any change in the business.
- Recurring “one-off items” – restructurings that happen every year are not one-offs.
- Factoring and supply-chain finance – they cosmetically improve cash flow in the short term without changing the business.
Reading “adjusted” figures critically
Many companies report “adjusted” figures such as adjusted EBITDA or adjusted earnings per share alongside the statutory numbers. That can make sense to strip out genuine special items. But they are not standardised – every company decides for itself what to leave out.
A checklist for the annual report
- Break down return on equity: does it come from margin, turnover or leverage?
- Calculate the cash conversion cycle over several years: is it getting longer?
- Compare profit and operating cash flow over five years – they should be roughly the same size.
- Read the reconciliation from adjusted to statutory figures: what is excluded, and does it recur?
- Read the notes on provisions, depreciation periods and revenue recognition – that’s where the judgement calls are.
Summary
DuPont analysis shows whether a return on equity comes from genuine earning power or from debt. The cash conversion cycle shows how much cash the business ties up and why growth costs liquidity. And comparing profit with cash flow reveals how robust the profits are. Master these three tools and you no longer read an annual report like a brochure, but like an auditor.
Time to practise
14 short exercises on this lesson – mistakes come back at the end. Then the lesson is complete and joins your review queue.
Test your knowledge
0/401A company has a 5% net margin, an asset turnover of 1.5 and financial leverage (total assets ÷ equity) of 2. What is its return on equity?
02Customers pay after 40 days on average, inventory sits for 50 days, and the company pays suppliers after 35 days. How long is the cash conversion cycle?
03What is a classic warning sign of poor earnings quality?
04Two firms each earn a 20% return on equity. Firm A does it with a 20% margin and little debt, firm B with a 2% margin and high leverage. What’s true?