Question

Problem 4-24
DuPont Analysis

A firm has been experiencing low profitability in recent years. Perform an analysis of the firm's financial position using the DuPont equation. The firm has no lease payments, but has a $3 million sinking fund payment on its debt. The most recent industry average ratios and the firm's financial statements are as follows:

	Industry Average Ratios
Current ratio	4.05x		Fixed assets turnover	7.68x
Debt/total assets	30.14%		Total assets turnover	3.00x
Times interest earned	18.35x		Profit margin	8.49%
EBITDA coverage	19.96x		Return on total assets	25.48%
Inventory turnover	11.77x		Return on common equity	36.47%
Days sales outstandinga	43 days		Return on invested capital	11.50%

^aCalculation is based on a 365-day year.

Balance Sheet as of December 31, 2014 (Millions of Dollars)
Cash and equivalents	$69		Accounts payable	$37
Accounts receivables	58		Other current liabilities	11
Inventories	124		Notes payable	40
Total current assets	$251		Total current liabilities	$88
			Long-term debt	22
			Total liabilities	$110
Gross fixed assets	168		Common stock	80
Less depreciation	54		Retained earnings	175
Net fixed assets	$114		Total stockholders' equity	$255
Total assets	$365		Total liabilities and equity	$365

Income Statement for Year Ended December 31, 2014 (Millions of Dollars)
Net sales	$730.0
Cost of goods sold	503.7
Gross profit	$226.3
Selling expenses	51.1
EBITDA	$175.2
Depreciation expense	14.6
Earnings before interest and taxes (EBIT)	$160.6
Interest expense	5.6
Earnings before taxes (EBT)	$155.0
Taxes (40%)	62.0
Net income	$93.0

Calculate those ratios that you think would be useful in this analysis. Do not round intermediate steps. Round your answers to two decimal places.

	Firm	Industry Average
Current ratio	x	4.05x
Debt to total capital	%	30.14%
Times interest earned	x	18.35x
EBITDA coverage	x	19.96x
Inventory turnover	x	11.77x
DSO	days	43days
F.A. turnover	x	7.68x
T.A. turnover	x	3.00x
Profit margin	%	8.49%
Return on total assets	%	25.48%
Return on common equity	%	36.47%
Return on invested capital	%	11.50%

Construct aa Du Pont equation, and compare the company's ratios to the industry average ratios. Do not round intermediate steps. Round your answers to two decimal places.

	Firm	Industry
Profit margin	%	8.49%
Total assets turnover	x	3.00x
Equity multiplier

Do the balance sheet accounts or the income statement figures seem to be primarily responsible for the low profits?
-Select-IIIIIIIVVItem 17

The low ROE for the firm is due to the fact that the firm is utilizing less debt than the average firm in the industry and the low ROA is mainly a result of an lower than average investment in assets.

Analysis of the extended Du Pont equation and the set of ratios shows that the turnover ratio of sales to assets is quite low. Either sales should be higher given the present level of assets, or the firm is carrying more assets than it needs to support its sales.

Analysis of the extended Du Pont equation and the set of ratios shows that the turnover ratio of sales to assets is quite low. Either sales should be lower given the present level of assets, or the firm is carrying less assets than it needs to support its sales.

Analysis of the extended Du Pont equation and the set of ratios shows that most of the Asset Management ratios are below the averages. Either assets should be higher given the present level of sales, or the firm is carrying less assets than it needs to support its sales.

The low ROE for the firm is due to the fact that the firm is utilizing more debt than the average firm in the industry and the low ROA is mainly a result of an excess investment in assets.

Which specific accounts seem to be most out of line relative to other firms in the industry?
-Select-IIIIIIIVVItem 18

The accounts which seem to be most out of line include the following ratios: Times Interest Earned, Total Asset Turnover, Profit Margin, Return on Assets, and Return on Equity.

The accounts which seem to be most out of line include the following ratios: Inventory Turnover, Days Sales Outstanding, Fixed Asset Turnover, Profit Margin, and Return on Equity.

The accounts which seem to be most out of line include the following ratios: Inventory Turnover, Days Sales Outstanding, Total Asset Turnover, Return on Assets, and Return on Equity.

The accounts which seem to be most out of line include the following ratios: Current, EBITDA Coverage, Inventory Turnover, Days Sales Outstanding, and Return on Equity.

The accounts which seem to be most out of line include the following ratios: Debt to Total Assets, Inventory Turnover, Total Asset Turnover, Return on Assets, and Profit Margin.

If the firm had a pronounced seasonal sales pattern, or if it grew rapidly during the year, how might that affect the validity of your ratio analysis?
-Select-IIIIIIIVVItem 19

If the firm had seasonal sales patterns, or if it grew rapidly during the year, many ratios would most likely be distorted.

It is more important to adjust the debt ratio than the inventory turnover ratio to account for any seasonal fluctuations.

Seasonal sales patterns would most likely affect the profitability ratios, with little effect on asset management ratios. Rapid growth would not substantially affect your analysis.

Rapid growth would most likely affect the coverage ratios, with little effect on asset management ratios. Seasonal sales patterns would not substantially affect your analysis.

Seasonal sales patterns would most likely affect the liquidity ratios, with little effect on asset management ratios. Rapid growth would not substantially affect your analysis.

How might you correct for such potential Problems?
-Select-IIIIIIIVVItem 20

It is possible to correct for such Problems by insuring that all firms in the same industry group are using the same accounting techniques.

It is possible to correct for such Problems by using average rather than end-of-period financial statement information.

It is possible to correct for such Problems by comparing the calculated ratios to the ratios of firms in a different line of business.

It is possible to correct for such Problems by comparing the calculated ratios to the ratios of firms in the same industry group over an extended period.

There is no need to correct for these potential Problems since you are comparing the calculated ratios to the ratios of firms in the same industry group.

Answer 1

Current Ratio = Current Assets / Current Liabilities = 251/88 = 2.85x

Debt to Total Capital = Total Debt / Total Debt + Shareholder's Equity = (notes payable + Long term Debt)/(notes payable + long term debt + Total stockholder's equity) = (40+22)/(40+22+255) = 19.56%

Times Interest Earned = EBIT/Interest Expense = 160.6/5.6 = 28.68x

EBITDA Coverage = (EBITDA + Lease Payment) / (Interest payment + Principal repayment + Lease payments) ; we are given that there are no lease payments but a $3 million sinking fund payment on debt. The sinking fund can be taken as proxy for principal repayment. EBITDA Coverage = (175.2)/(5.6+3) = 20.37x

Inventory Turnover = Cost of goods sold/average inventory = 503.7/124 (using year end inventory since information missing for average) = 4.06x

DSO = [Accounts Receivable/Net Credit Sales] * 365 = since credit sales data is not given, we will use the sales figure as proxy. DSO = (58/730)*365 = 29 days

F.A Turnover = Net Sales / (Fixed Assets - Accumulated Depreciation) = 730/(168-54) = 6.40x

T.A. Turnover = Net Sales / Average Total Assets = 730/365 = 2

Profit Margin = Net Income / Net Sales = 93/730 = 12.74%

Return on Total Assets = Net Income / Average TA = 93/365 = 25.48%

Return on Common Equity = Net Income / Shareholders' Equity = 93/255 = 36.47%

Return on Invested capital = (Net Income - Dividends)/Total Capital Invested; the invested capital here is simply Total Assets minus the non interest bearing liabiliies (Accounts Payable & Other Liabilities) and cash which will be (365-69-37-11) = 248. Hence RoIC = 93/248 = 37.50%

The table comparing the various ratio is presented below:

Now we can move to Dupont analysis

Equity Multiplier = Total Assets / Shareholder's Equity = 365/255 = 1.43x

Dupont Analysis:it breaks down ROE into below mentioned components for more granular analysis:

ROE = Profit Margin * TA Turnover * Equity Multiplier = (Net Income/Net Sales) * (Net Sales/TA) * (TA/Shareholder Equity)

Note that due to rounding off the decimals may not match exactly.

The primary difference is in the efficiency ratio which are balance sheet items where the company lags the industry average numbers.

Part 17: Analysis of the extended Du Pont equation and the set of ratios shows that the turnover ratio of sales to assets is quite low. Either sales should be higher given the present level of assets, or the firm is carrying more assets than it needs to support its sales.

Part 18: The accounts which seem to be most out of line include the following ratios: Inventory Turnover, Days Sales Outstanding, Fixed Asset Turnover, Profit Margin, and Return on Equity.

Part 19: If the firm had seasonal sales patterns, or if it grew rapidly during the year, many ratios would most likely be distorted. especially since we are using year end numbers and not average due to non-availability of average numbers

Part 20: It is possible to correct for such Problems by using average rather than end-of-period financial statement information.