Question

In: Accounting

An analysis of company performance using DuPont analysis Walking down the hall of your office building...

An analysis of company performance using DuPont analysis

Walking down the hall of your office building with a laptop in his hand, your friend and colleague, Musashi, stepped into your office and asked the following.

MUSASHI: Do you have 10 or 15 minutes that you can spare?

YOU: Sure, I’ve got a meeting in an hour, but I don’t want to start something new and then be interrupted by the meeting, so how can I help?

MUSASHI: I’ve been reviewing the company’s financial statements and looking for general ways to improve our performance, in general, and the company’s return on equity, or ROE, in particular. Susan, my new team leader, suggested that I start by using a DuPont analysis, and I’d like to run my numbers and conclusions by you, to see if I’ve missed anything.

Here are the balance sheet and income statement data that Susan gave me, and here is my spreadsheet with my calculations. Could you start by making sure that my numbers are correct?

YOU: Give me a minute to look at these financial statements and to remember what I know about the DuPont analysis.

Balance Sheet Data

Income Statement Data

Cash $700,000 Accounts payable $840,000 Sales $14,000,000
Accounts receivable 1,400,000 Accruals 280,000 Cost of goods sold 7,000,000
Inventory 2,100,000 Notes payable 1,120,000 Gross profit 7,000,000
Current assets 4,200,000 Current liabilities 2,240,000 Operating expenses 3,500,000
Long-term debt 3,640,000 EBIT 3,500,000
Total liabilities 5,880,000 Interest expense 1,556,800
Common stock 980,000 EBT 1,943,200
Net fixed assets 5,600,000 Retained earnings 2,940,000 Taxes 680,120
Total equity 3,920,000 Net income $1,263,080
Total assets $9,800,000 Total debt and equity $9,800,000

YOU: If I remember correctly, the DuPont equation breaks down our ROE into three component ratios: the   , the total asset turnover ratio, and the   .

And, according to my understanding of the DuPont equation and its calculation of ROE, the three ratios provide insights into the company’s   , effectiveness in using the company’s assets, and   .

Now, let’s see your spreadsheet with your ratios, and then we can talk about possible strategies that will improve the ratios. I’m going to check the box to the side of your calculated value if your calculation is correct and leave it unchecked if your calculation is incorrect.

DuPont Analysis Ratios (Value)

Correct?

Gross profit margin (50.00%)
Operating profit margin (13.88%)
Net profit margin (12.89%)
Return on equity (30.78%)
Total asset turnover (1.43x)
Debt ratio (60.00%)
Equity multiplier (1.67)

MUSASHI: OK, it looks like I’ve got a couple of incorrect values, so show me your calculations, and then we can talk strategies for improvement.

YOU: I’ve just made rough calculations, so let me complete this table by inputting the components of each ratio and its value:

Cepeus Manufacturing Inc. DuPont Analysis

Calculation

Value

Ratios

Numerator Denominator
Gross profit margin (%) / =
Operating profit margin (%) / =
Net profit margin (%) / =
Return on equity (%) / =
Total asset turnover / =
Debt ratio (%) / =
Equity multiplier / =

MUSASHI: I see what I did wrong in my computations. Thanks for reviewing these calculations with me. You saved me from a lot of embarrassment! Susan would have been very disappointed in me if I had showed him my original work.

So, now let’s switch topics and identify general strategies that could be used to positively affect Cepeus’s ROE.

YOU: Great!

So given your knowledge of the component ratios used in the DuPont equation, which of the following strategies should improve the company’s ROE? Check all that apply.

Reduce the company’s operating expenses, its cost of goods sold, and/or the interest rate on its borrowed funds because this will increase the company’s net profit margin.

Decrease the amount of debt financing used by the company, which will decrease the total asset turnover ratio.

Increase the interest rate on its notes payable or long-term debt obligations because it will reduce the company’s net profit margin.

Increase the cost and amount of assets necessary to generate each dollar of sales because it will increase the company’s total asset turnover.

MUSASHI: I think I understand now. Thanks for taking the time to go over this with me, and let me know when I can return the favor.

Solutions

Expert Solution

Firstly to understand the concept of Du point Analysis

Du point analysis refers to such analysis which puts emphasis puts focus on the Return on Equity and Return on the asset. As both focus on the company's profitability and margin which determines its Return on the asset.

Formula For its computation:

Return on Asset =(Net Income)/(Revenue) *(Revenue/Assets)=Profit Margin*Asset Turnover

Return On Equity =(Net Income)/(Revenue)*(Revenue/Assets)*(Asset/Equity)= Return on asset *EquityMultiplier.

Solution:

Workings

Impact of the following on Dupoint analysis:

Particulars Impact On Du point Reason
Reduction in Operating Expense Increase in return of ROA of asset With the reduction of operating expenses profit will increase as a result there will be an increase in Return on asset
Decrease Debt Of company Will decrease the ROE With more debt the burdern is leveraged as a result ROE Increases in case of debt increases and decreases when debt decreases.
Increase the interest rate on its notes payable or long-term debt obligations because it will reduce the company’s net profit margin Will decrease ROA and ROE As the profit margin will decline with the increase in interest charges.
Increase the cost and amount of assets necessary to generate each dollar of sales because it will increase the company’s total asset turnover Will Increase ROA and ROE with an increase in sale the profit margin will also increase.As a result ROE/ROA will increase

Conclusion:

In the aforesaid method the Du-point important ratios are computed


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