Ratio Analysis Concept Card Template (DuPont, Cash Conversion Cycle)

Ratio Analysis Concept Card: [Your course or company]

A concept card for financial ratio analysis as it is taught in an MBA financial accounting and corporate finance core: profitability and returns with the three-step and five-step DuPont decomposition, liquidity, solvency, efficiency and the cash conversion cycle, and the quality-of-earnings red flags that tell you when the ratios cannot be trusted. It is for MBA students, candidates preparing for consulting, banking and credit interviews, and managers who read peer benchmarks. It shows every ratio with its formula, an Excel formula on a fixed statement layout, and fully computed examples, and it explains how IFRS 16, US GAAP ASC 842 and the IFRS 18 subtotals (from 2027) change the numbers. Source basis: the DuPont system (developed at DuPont in the 1910s), Richards and Laughlin (1980), Sloan (1996), Beneish (1999), Nissim and Penman (2001) and the IFRS and FASB standards named in the text, written up in original words with fictional companies. Replace every [bracketed] value and every row marked Example. This is a learning aid, not investment or credit advice.

Document control

Contents

1. When to use it
2. The idea in plain language
3. Formulas and notation
4. Assumptions and limits
5. How managers use it
6. Worked example A (fully solved)
7. Quality of earnings red flags
8. Worked example B (half solved)
9. Exercise C (unsolved)
10. Connections to other cards
11. Common mistakes and misconceptions
12. Self-test questions
13. My notes and next steps
14. Sources and further reading
15. Answer key

When to use it

Use ratio analysis when you need to:

• Explain performance: why return on equity moved, and whether the cause is margin, asset use or leverage.
• Compare a company with its own history, with peers (finance/comparable-companies-analysis) or with a plan.
• Assess credit risk: liquidity, leverage and coverage for a loan, a bond or a supplier decision (finance/credit-memo, finance/bond-credit-analysis).
• Diagnose working capital: how many days of cash are tied up in inventory and receivables (finance/working-capital-review).
• Screen earnings quality before you trust any of the above (finance/quality-of-earnings-scope).

Do not use ratios to value a company on their own (use mba/mba-dcf-valuation-card), and do not compare ratios across companies that use different accounting (IFRS 16 against ASC 842 operating leases, for example) without adjusting.

The idea in plain language

A ratio divides one number by another so that companies of different sizes, or one company over time, can be compared. The numbers mean something only against a benchmark and only after you know how they were defined.

DuPont analysis answers the owner's question: "how much profit do I earn on my equity, and why?" It splits return on equity (ROE) into pieces that managers control in different ways:

• Three steps: ROE = how much of each sale is profit (net margin) x how many sales each unit of assets produces (asset turnover) x how many assets each unit of equity supports (equity multiplier, a leverage measure).
• Five steps: the margin is split further into how much of pre-tax profit survives tax (tax burden), how much of operating-level profit survives financing costs (interest burden), and the operating-level margin.

Two companies with the same 13% ROE can be completely different businesses: a high-margin, low-turnover luxury brand and a thin-margin, high-turnover discounter, or a company that earns it with leverage rather than operations.

The other families answer narrower questions: liquidity (can it pay what falls due within a year?), solvency (can it carry its debt over time?), efficiency (how hard do the assets work, and how long is cash tied up in the operating cycle?) and quality of earnings (do accounting profits turn into cash, and are the estimates behind them reasonable?).

Formulas and notation

Three-step DuPont (with average balances $\bar{A}$ and $\bar{E}$):

$ROE = \frac{NI}{\bar{E}} = \frac{NI}{S} \times \frac{S}{\bar{A}} \times \frac{\bar{A}}{\bar{E}}$

Five-step DuPont, with EBIT defined as profit before financing and income taxes (the IFRS 18 subtotal):

$ROE = \frac{NI}{PBT} \times \frac{PBT}{EBIT} \times \frac{EBIT}{S} \times \frac{S}{\bar{A}} \times \frac{\bar{A}}{\bar{E}}$

Return on invested capital, consistent numerator and denominator:

$ROIC = \frac{OP \times (1 - t)}{\overline{IC}}, \qquad IC = E + D + LL - Cash - Inv_{assoc}$

Cash conversion cycle (Richards and Laughlin 1980):

$CCC = DIO + DSO - DPO = \frac{\overline{Inv}}{COGS}\times 365 + \frac{\overline{AR}}{S}\times 365 - \frac{\overline{AP}}{COGS}\times 365$

Accrual ratio (balance of profit not backed by operating cash, after Sloan 1996):

$Accruals = \frac{NI - CFO}{\bar{A}}$

Ratio map. One line per ratio you will meet in a core course.

Assumptions and limits

• Benchmarks are everything. There is no "good" current ratio in general. A grocer runs below 1.0 because it is paid before it pays suppliers; a machine builder needs far more.
• Definitions vary. Average or closing balances, which "EBIT", leases in or out of debt, gross or net of cash. Fix the definitions and apply them to every year and every peer.
• Leases change everything. Under IFRS 16 store leases sit in debt and the lease cost is split into depreciation and interest, so EBITDA, operating profit, debt and CFO are all higher than under ASC 842 operating lease accounting. Compare IFRS and US GAAP retailers only after adjusting one to the other.
• IFRS 18 changes the subtotals. From annual periods beginning on or after 1 January 2027, IFRS reporters present operating profit and profit before financing and income taxes as defined subtotals. Ratios built on a company's old IAS 1 "operating profit" will not match the restated comparatives. Use the IFRS 18 subtotals for new work, and use management-defined performance measures (MPMs) only through their reconciliation note.
• Year-end balances can be managed. Retailers choose a year end after the peak season; any company can pay suppliers late or collect early around the reporting date. Averages of quarterly balances are better when available.
• Ratios describe; they do not explain. A falling margin can come from price, mix, cost or accounting. Use the ratio to find the question, then read the notes and talk to management.

How managers use it

• Boards and investors track ROE and ROIC against the cost of capital (mba/mba-capm-wacc-card): growth that earns below the cost of capital destroys value even when profit rises.
• Lenders set covenants such as maximum net debt to EBITDA and minimum liquidity, and test them each quarter (finance/covenant-compliance-certificate). Treasurers forecast the covenant ratios before every major decision.
• Operations and merchandising manage DIO and the cash conversion cycle: each day of inventory at Northfield's FY2026 cost of sales ties up about USD 0.78m (284.2 / 365).
• Finance teams explain variances (finance/variance-analysis) by decomposing margin and turnover, and investor relations teams prepare the MPM reconciliations that analysts will use from 2027.

Worked example A (fully solved)

Exhibit A1. Northfield Outdoor Co. inputs (USD m, fictional; full statements in mba/mba-three-statements-card).

Step 1. Profitability and DuPont, FY2026 (FY2025 for comparison).

Check: 0.0381 x 1.044 x 3.318 = 0.1319, and 0.771 x 0.629 x 0.0785 x 1.044 x 3.318 = 0.1319. Both products equal ROE exactly because each numerator cancels the next denominator.

Reading. ROE fell by 0.93 percentage points. Turnover improved (more revenue per unit of assets, helped by online growth from 33.3% to 37.1% of revenue), and leverage fell slightly as the loan was prepaid. The whole decline sits in the EBIT margin (8.59% to 7.85%): restructuring and impairment of 6.6 cost 1.29 points of margin. On the adjusted measure the operating margin rose, which is exactly why the MPM reconciliation matters: a reader must decide whether store closures are a one-off or a recurring cost of running a store estate. ROIC of 8.0% should be compared with the company's cost of capital (mba/mba-capm-wacc-card): at an illustrative cost of capital of 9%, the business would not be covering it.

Step 2. Liquidity and solvency, closing balances.

Reading. Leverage measured on the balance sheet improved, but liquidity weakened sharply: the quick ratio almost halved because cash fell from 50.5 to 22.0 while inventory absorbed the difference. The current ratio hides this, because inventory counts as a current asset. Net debt rose by 34.5 even though the loan fell by 10.0: lease liabilities grew by 16.0 (new stores) and cash fell by 28.5.

Step 3. Efficiency and the cash conversion cycle.

DPO uses cost of sales because purchases are not disclosed; with purchases (cost of sales plus the increase in inventory) the FY2026 DPO would be lower. The chart shows the cycle lengthening on both sides: more days of inventory and fewer days of supplier credit.

Step 4. Quality of earnings.

The table shows why a single cash ratio can mislead under IFRS 16: lease principal sits in financing, so CFO looks large relative to profit for any company with big leases. Subtracting lease principal gives a figure comparable to a US GAAP company with operating leases (28.3 in FY2026, the same as the ASC 842 view computed in mba/mba-cash-flow-statement-card).

Conclusion. Northfield's returns slipped modestly, but the more important story is cash: the cycle lengthened by 8.6 days, inventory rose 19.8% against 9.4% sales growth, and cash after leases fell to about 1.45 times profit. The next questions are about the inventory (age profile, write-down policy under IAS 2, sell-through of seasonal lines) and about whether the restructuring is really a one-off.

Quality of earnings red flags

Two published screens are worth knowing by name: the accrual anomaly (Sloan 1996: high accruals predicted lower future earnings and returns) and the Beneish (1999) M-score, a probit model built on eight ratios (including days receivables, gross margin, asset quality and accruals) to flag likely earnings manipulators. Both were estimated on US companies and are screens, not proof. Altman's (1968) Z-score is the classic solvency screen; it was estimated on US manufacturers and does not transfer directly to retailers with large IFRS 16 lease liabilities.

Worked example B (half solved)

Compute Northfield's FY2025 five-step DuPont and cash conversion cycle. Inputs: profit 19.6, profit before income taxes 25.6, profit before financing and income taxes 40.2, revenue 468.0, cost of sales 262.1, average total assets 471.25, average equity 138.8, average inventories 98.5, average receivables 14.5, average payables 53.5.

Then explain in two sentences which DuPont component moved most between FY2025 and FY2026 and why.

Exercise C (unsolved)

Corvane Robotics (fictional growth-stage warehouse-robotics company) reports for FY2026 (USD m): revenue 84.0, cost of sales 50.4, operating loss 6.0, loss for the year 5.3, average total assets 120.0, average equity 78.0, trade receivables 18.0 opening and 24.0 closing, inventories 16.0 opening and 21.0 closing, trade payables 8.0 opening and 10.4 closing, closing current assets 64.0, closing current liabilities 28.0, closing cash 30.0, and net cash used in operating activities 4.1.

1. Compute gross margin, operating margin, net margin, asset turnover, equity multiplier and ROE, and check that the three-step product equals ROE.
2. Compute the current ratio and the quick ratio (cash plus closing receivables).
3. Compute DSO, DIO, DPO and the cash conversion cycle with average balances.
4. Compute CFO divided by the loss for the year. Why is a ratio of CFO to profit hard to read for a loss-making company?
5. In five sentences, compare Corvane's ratio profile with Northfield's. Which ratios would you not compare across the two companies at all, and why?

Connections to other cards

Common mistakes and misconceptions

• Mixing stocks and flows on different dates. Dividing a full-year flow by a closing balance biases ratios when the balance sheet is growing. Use averages and say so.
• A DuPont product that does not equal ROE. If your components use different profit or balance definitions, the product breaks. Each numerator must cancel the next denominator.
• Comparing IFRS 16 and ASC 842 retailers directly. IFRS 16 raises EBITDA, operating profit, CFO and debt. Adjust before comparing margins, leverage or cash conversion.
• Calling the current ratio "liquidity". Inventory is the least liquid current asset. Northfield's current ratio fell modestly while its quick ratio almost halved.
• Using adjusted figures without the reconciliation. An MPM or non-GAAP number is management's view. Start from the IFRS 18 subtotal and add back only what you agree is non-recurring.
• Treating high ROE as good news. ROE can rise because equity shrinks (buybacks, losses written against equity) or because leverage rises. Check the equity multiplier and ROIC.
• Computing DPO on revenue. Payables relate to purchases at cost; use cost of sales (or purchases) consistently.
• Comparing ratios across business models. A robotics company's inventory days, margins and asset turnover have little to do with a retailer's. Compare with peers in the same model.
• Ignoring seasonality. A retailer's year-end inventory and payables depend on where the season sits. Use quarterly averages when you can.

Self-test questions

1. Write the three-step and five-step DuPont identities and say why each product equals ROE exactly.
2. Northfield's ROE fell from 14.12% to 13.19%. Which component explains the fall?
3. Why did the quick ratio fall much more than the current ratio?
4. Net debt including leases rose by 34.5 although the loan fell by 10.0. Reconcile the movement.
5. Define the cash conversion cycle and compute Northfield's FY2026 value from DIO 142.6, DSO 11.6, DPO 71.6.
6. Give two reasons why CFO divided by profit is high for an IFRS 16 retailer even when earnings quality is ordinary.
7. Under IFRS 18, which subtotal would you use as EBIT in the five-step DuPont, and why?
8. A company's gross margin rises while inventory grows twice as fast as cost of sales. Name two explanations, one benign and one worrying.
9. What does the Sloan (1996) accrual anomaly say?
10. Why is ROIC more useful than ROE for judging operating performance?

My notes and next steps

Sources and further reading

• DuPont system of financial control: developed inside the DuPont company in the 1910s and usually credited to F. Donaldson Brown; the five-step extension is the textbook form used in financial statement analysis.
• Richards, V. D., and Laughlin, E. J. (1980). A cash conversion cycle approach to liquidity analysis. Financial Management, 9(1), 32-38.
• Altman, E. I. (1968). Financial ratios, discriminant analysis and the prediction of corporate bankruptcy. The Journal of Finance, 23(4), 589-609.
• Sloan, R. G. (1996). Do stock prices fully reflect information in accruals and cash flows about future earnings? The Accounting Review, 71(3), 289-315.
• Beneish, M. D. (1999). The detection of earnings manipulation. Financial Analysts Journal, 55(5), 24-36.
• Nissim, D., and Penman, S. H. (2001). Ratio analysis and equity valuation: from research to practice. Review of Accounting Studies, 6(1), 109-154.
• Dechow, P. M., and Dichev, I. D. (2002). The quality of accruals and earnings: the role of accrual estimation errors. The Accounting Review, 77(Supplement), 35-59.
• IFRS Foundation: IFRS 18 (annual periods beginning on or after 1 January 2027), IAS 7, IFRS 16, IAS 2. https://www.ifrs.org (checked 2026-10-28). FASB: ASC 842 (ASU 2016-02), ASC 230. https://www.fasb.org (checked 2026-10-28).
• Textbooks (further reading by name only): Penman, S. H., Financial Statement Analysis and Security Valuation (McGraw Hill); Palepu, K. G., Healy, P. M. and Wright, S., Business Analysis and Valuation: IFRS Edition (Cengage); Koller, T., Goedhart, M. and Wessels, D., Valuation: Measuring and Managing the Value of Companies (Wiley).
• Open resource: OpenStax, Principles of Accounting, Volume 1: Financial Accounting (CC BY-NC-SA 4.0), openstax.org.

Answer key

Worked example B. Interest burden 25.6 / 40.2 = 0.637. EBIT margin 40.2 / 468.0 = 0.0859 (8.59%). Equity multiplier 471.25 / 138.8 = 3.395. ROE = 0.766 x 0.637 x 0.0859 x 0.993 x 3.395 = 0.1412 (14.12%) at full precision (the rounded factors give 0.1413), equal to 19.6 / 138.8. DIO = 98.5 / 262.1 x 365 = 137.2 days. DSO = 14.5 / 468.0 x 365 = 11.3 days. DPO = 53.5 / 262.1 x 365 = 74.5 days. CCC = 137.2 + 11.3 - 74.5 = 74.0 days. Between FY2025 and FY2026 the EBIT margin moved most (8.59% to 7.85%), because the 6.6 of restructuring and impairment fell within operating profit while revenue grew only 9.4%; turnover improved and leverage fell slightly, so neither explains the lower ROE.

Exercise C.

(4) With both numbers negative, the ratio is positive and a "better" (smaller) cash burn gives a smaller ratio, so the usual reading reverses; compare cash burn with the loss directly instead (cash burn 4.1 is less than the 5.3 loss because depreciation and share-based compensation are non-cash, partly offset by the working capital build). (5) Corvane has low leverage (equity-funded), high liquidity from its latest equity raise, slow asset turnover, long receivable days typical of enterprise equipment sales, and negative returns. Margins and returns are comparable in concept but not in level; working capital days and asset turnover reflect different business models and should be compared only with robotics peers.

Self-test.

1. ROE = (NI/S)(S/A)(A/E) and ROE = (NI/PBT)(PBT/EBIT)(EBIT/S)(S/A)(A/E); each numerator cancels the next denominator, leaving NI/E.
2. The EBIT margin (8.59% to 7.85%), driven by 6.6 of restructuring and impairment; turnover rose and the tax burden was stable.
3. Cash fell from 50.5 to 22.0 and inventory rose by 20.0; the current ratio counts inventory, the quick ratio does not.
4. Lease liabilities +16.0 (169.0 to 185.0), loan -10.0, cash -28.5 (which raises net debt by 28.5): 16.0 - 10.0 + 28.5 = 34.5.
5. CCC = DIO + DSO - DPO = 142.6 + 11.6 - 71.6 = 82.6 days.
6. Lease principal is a financing outflow, so CFO excludes a large recurring cash cost; and depreciation of right-of-use assets is a large non-cash charge added back. (Under the amended IAS 7, interest paid is also outside CFO.)
7. Profit before financing and income taxes, because it is a defined IFRS subtotal that sits exactly above the financing category, so the interest burden captures all financing costs including lease interest.
8. Benign: a planned build of new-season stock or a product mix shift towards higher-margin own brands. Worrying: too few write-downs of slow-moving stock, or costs capitalised into inventory, both of which flatter the margin.
9. Firms with high accruals (profit well above operating cash flow) tended to have lower future earnings and stock returns; the market appeared to overweight the accrual component of earnings.
10. ROIC measures operating returns on all capital that funds operations, independent of how it is financed; ROE mixes operating performance with leverage.

Revision history

Standard and licence note

Based on the published research named above (Richards and Laughlin 1980, Altman 1968, Sloan 1996, Beneish 1999, Nissim and Penman 2001, Dechow and Dichev 2002), the DuPont decomposition as commonly taught, and the IFRS and FASB standards named in the text, using standard numbers and effective dates only, checked on ifrs.org and fasb.org on 2026-10-28. The explanations, exhibits, red-flag checklist and questions are original; Northfield Outdoor Co. and Corvane Robotics are fictional. The template is independent and not affiliated with or endorsed by the IFRS Foundation, the FASB or any business school. Check the current official versions before you rely on any date or requirement. Template licence: MIT.