FIN 4596

YAKSICKLECTUREONDUPONTFORMULAANDRATIOBUSINESSMODEL-March52015Autosaved.pptx

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DuPont System of Business Financial Analysis

The DuPont system of analysis is used to dissect the firm’s financial statements and to assess its financial condition from three perspectives: Operations, Investment, and Financing.

Developed by Dupont (major US chemical company) financial staff in the 1920s to enable management to gain a deeper understanding of how to raise the Return on Owners’ Equity (ROE) by better management of three key components of its business:

Operational Efficiency: (Net Profit Margin)

Asset Use Efficiency: (Total Asset Turnover), where TAT = Sales/Total Assets, and

Financial Leverage (Debt) Management: (Financial) Leverage Multiplier = Assets/Total Equity = (1 + D/E),

SOURCE: Ross, et al., Ch. 3

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DuPont System of Business Financial Analysis

USE of Dupont System:

If ROE is unsatisfactory for some unspecified reason, then the Dupont Identity (see below) tells the analyst where to start searching for the reason(s) for the unsatisfactory ROE

Dupont Identity:

ROE = Profit Margin x Total Asset Turnover x Equity Multiplier

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Derivation of DuPont IDENTITY

Both ROE (defined as Net Income/Equity) and ROA (Net Income/Total Assets) are measures of profitability.

They differ because of debt financing (aka Financial Leverage)

Thus, (1) ROE = ROA x Equity Multiplier.

After some algebra, we obtain a more detailed version of (1):

(2) ROE = Net Income/Sales x Sales/Assets x Assets/Total Equity.

Substituting into (2) the definitions of key ratios, we obtain the Identity:

(3) ROE = Profit Margin x Total Asset Turnover x Equity Multiplier

NOTES: ROA = (Net Income/Sales) x (Sales/assets)

Equity Multiplier = Assets/Total Equity = (D +E)/E) = (1 + D/E)

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Simplifying the Modified DuPont Formula

We can simply the preceding formula by:

1) replacing the first two terms by the ROA ratio, since ROA = Net profit margin  Total asset turnover.

2) Thus, ROE = ROA x FLM.

NOTE: The ROAssets belongs ENTIRELY to common stockholders. Hence, FLM is the equity “multiplier,” adjusting UPWARDS the ROEquity.

3) Recall, that we can reexpress ROA as follows:

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KEY FORMULA: Modified Dupont Formula

ROE = (Net Profit/Sales) x (Sales/total Assets) x (Assets/(Assets – Liabilities)), or

ROE = Net Profit Margin x Total Asset Turnover x FLM

Interpretation:

Operations: ROE can be improved by improving the profitability of operations (Net Profit Margin), e.g., improve production and sales efficiency by cutting costs and charging a premium price.

Investment: ROE can be improved by more effective use of assets that generate sales (Total Asset Turnover).

NOTE: The TAT ratio is a “multiplier”, telling us how many times the profit margin is EARNED EACH YEAR!

Financing: ROE can be improved by optimal use of Debt (Liabilities) in the capital structure. The key driver for management is the Financial Leverage Multiplier (FLM). FLM is the ratio of Total Assets to Common Stock Equity, where Equity = Assets – Liabilities.

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Applying the Dupont Formula

The research goal underlying the development of the Dupont Formula was to obtain a simple model of a business presented in an accounting ratio format.

The model is illustrated in the following diagram.

How do we use this diagram to “diagnose” the financial “health” of a company and the fundamental cause(s) of its under/over performance of the company, relative to industry (competitors’) performance?

NOTE: Method of diagnosis is very similar to “differential diagnosis” taught to medical students!

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Figure 3.2 DuPont System of Analysis

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Numerical Example: Modified Dupont Formula

Data for Bartlett Company:

Net Profit Margin = 7.2%

Total Asset Turnover = 0.85

Financial Leverage Multiplier = 2.051

Substituting these values into the following Modified Dupont Formula, we obtain:

ROE = ROA x FLM

= Net Profit Margin x TAT x FLM

= 7.2% x (0.85) x 2.051

= 6.1% x 2.051

= 12.6%

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EXAMPLE OF DIAGNOSIS Strategy:

I. Industry Comparison Analysis (“Top Down” strategy).

Suppose Bartlett’s ROE of 12.6% is BELOW the industry average? Why is this so? Diagnosis Strategy:

1. Compare ROA and FLM to industry average.

2. Conclusion: FLM is identical to Industry Average. Hence, the “cause” must lie in the ROA being below industry average.

3. Hence, move to left in the chart and analyze the two inputs into ROA ratio: Net Profit Margin and Total Asset Turnover (TAT).

4. Conclusion: Net Profit Margin matches industry average. Hence, the “problem” MAY lie in the TAT.

5. Continue moving to the left in the TAT branch of the tree structure

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EXAMPLE OF DIAGNOSIS Strategy:

I. What if Scenario Analysis: “Bottom Up” strategy

ISSUE: What is the impact on ROE if management decides to increase the level of Long-Term Debt?

Diagnosis Strategy: Start from left-hand side of Tree and “walk” through the branch connecting Long Term Debt to the Financial Leverage Multiplier.

Conclusion: By increasing debt (and prudently investing it, i.e. rate of return on debt-financed project > interest cost of debt), management increases total liabilities which, in turn reduces equity. Thereby, increasing FLM and ROE.

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