Question

An analysis of company performance using DuPont analysis

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

AKIRA: 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?

AKIRA: 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. Emma, 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 Emma gave me, and here are my notes 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	$1,300,000	Accounts payable	$1,560,000	Sales	$26,000,000
Accounts receivable	2,600,000	Accruals	520,000	Cost of goods sold	15,600,000
Inventory	3,900,000	Notes payable	2,080,000	Gross profit	$10,400,000
Current assets	$7,800,000	Current liabilities	$4,160,000	Operating expenses	6,500,000
		Long-term debt	4,420,000	EBIT	$3,900,000
		Total liabilities	$8,580,000	Interest expense	780,000
		Common stock	1,755,000	EBT	$3,120,000
Net fixed assets	7,800,000	Retained earnings	5,265,000	Taxes	1,092,000
		Total equity	$7,020,000	Net income	$2,028,000
Total assets	$15,600,000	Total debt and equity	$15,600,000

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 notes with your ratios, and then we can talk about possible strategies that will improve the ratios. In the dropdown lists next to your values I’m going to select correct if your calculation is correct and incorrect if your calculation is incorrect.

		Canis Major Veterinary Supplies Inc. DuPont Analysis
Ratios	Value	Correct/Incorrect	Ratios	Value	Correct/Incorrect
Profitability ratios			Asset management ratio
Gross profit margin (%)	40.00	???????????	Total asset turnover	1.67	??????????
Operating profit margin (%)	12.00	???????????
Net profit margin (%)	13.00	???????????	Financial ratios
Return on equity (%)	39.43	???????????	Equity multiplier	1.82	??????????

AKIRA: 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:

Note: Do not round intermediate calculations. Round final answers to the nearest whole number.

Canis Major Veterinary Supplies Inc. DuPont Analysis
		Calculation			Value
Profitability ratios	Numerator		Denominator
Gross profit margin (%)	??????	/	????????	=	???
Operating profit margin (%)	??????	/	????????	=	???
Net profit margin (%)	??????	/	????????	=	???
Return on equity (%)	??????	/	????????	=	???
Asset management ratio
Total asset turnover	??????	/	????????	=	???
Financing ratios
Equity multiplier	??????	/	????????	=	???

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

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

YOU: OK, 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.

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

B) Increase the efficiency of its assets so that it generates more sales with each dollar of asset investment and increases the company’s total asset turnover.

C) Increase the firm’s bottom-line profitability for the same volume of sales, which will increase the company’s net profit margin.

D) Use more debt financing in its capital structure and increase the equity multiplier.

AKIRA: 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.

Answer 1

i) The DuPont equation breaks down our ROE into three component ratios: the Net profit margin , the total asset turnover ratio, and the Leverage.
ii) And, according to my understanding of the DuPont equation and its calculation of ROE, the three ratios provide insights into the company’s profitability by giving income driven by company per dollar of sales (Net profit margin) , effectiveness in using the company’s assets, and Financial Leverage provide insight to Solvency of company.

iii)

	Canis Major Veterinary Supplies Inc. DuPont Analysis
Ratios	Value	Correct/Incorrect	Ratios	Value	Correct/Incorrect
Profitability ratios			Asset management ratio
Gross profit margin (%)	40.00	correct	Total asset turnover	1.67	Correct
Operating profit margin (%)	12.00	Incorrect
Net profit margin (%)	13.00	Incorrect	Financial ratios
Return on equity (%)	39.43	Incorrect	Equity multiplier	1.82	Incorrect

iv)

Canis Major Veterinary Supplies Inc. DuPont Analysis
		Calculation			Value
Profitability ratios	Numerator		Denominator
Gross profit margin (%)	$10,400,000	/	$26,000,000	=	40
Operating profit margin (%)	$3,900,000	/	$26,000,000	=	15
Net profit margin (%)	$2,028,000	/	$26,000,000	=	7.8
Return on equity (%)	$2,028,000	/	$7,020,000	=	28.89
Asset management ratio
Total asset turnover	$26,000,000	/	$15,600,000	=	1.67
Financing ratios
Equity multiplier	$15,600,000	/	$7,020,000	=	2.222

v)Strategies should improve the company’s ROE:

ROE= Net Income / Sales (Net profit margin) X Revenue / Avg total assets (Total asset turnover) X
  Avg total assets / Avg shareholder's equity (Leverage or equity multiplier)

A)Increase the interest rate on its notes payable or long-term debt obligations will decrease net income. So, it is a incorrect strategy as decrease in net profit margin will decrease the company's ROE.
B) Increase the efficiency of its assets so that it generates more sales with each dollar of asset investment and increases the company’s total asset turnover. This strategy will have positive impact ROE will certainly improve it.
C) Increase the firm’s bottom-line profitability for the same volume of sales, which will increase the company’s net profit margin will also improve company's ROE as given in formula any improvement in net profit margin will improve return on equity.
D) Use more debt financing in its capital structure and increase the equity multiplier because shareholder's equity will decrease thus will improve company's ROE. However, increasing leverage will have dual impact, high debt will decrease net income as interest will be increased. Increasing equity multiplier also increase solvency & liquidity risk.

** Avg refers to average- it is more inclined to real market practice. It is calculated by taking Current and previous year data for a particular ratio (assets, equity etc) and dividing the sum by two. If data for previous year is not given, calculate normally without taking an average.