Question

Your ROI is now 12%, above the industry average of 11%. Your old NPM was 5%, and your old TAT was 2.

Old ROI = 10% = 5% x 2.

If new ROI = 6% x 2, what do you conclude, and where do you look for answers?

Answer 1

The DuPont system of financial analysis uses a financial model that is based on the return on equity (ROE) of a firm. The DuPont system of financial analysis is used to examine a firm’s financial statements and financial performance. The three variables that determine ROE are net profit margin (NPM), total asset turnover (TAT), and the equity multiplier (EM).

Net profit margin (NPM):operating efficiency

Total asset turnover (TAT):asset use efficiency

Equity multiplier (EM):use of financial leverage

This analysis has 3 components to consider;

1.Profit Margin– This is a very basic profitability ratio. This is calculated by dividing the net profit by total revenues. This resembles the profit generated after deducting all the expenses. The primary factor remains to maintain healthy profit margins and derive ways to keep growing it by reducing expenses, increasing prices etc, which impacts ROE.

For example; Company X has Annual net profits of Rs 1000 and Annual turnover of Rs 10000. Therefore the net profit margin is calculated as

Net Profit Margin= Net profit/ Total revenue= 1000/10000= 10%

2. Total Asset Turnover– This ratio depicts the efficiency of the company in using its assets. This is calculated by dividing revenues by average assets. This ratio differs across industries but is useful in comparing firms in the same industry. If the company’s asset turnover increases, this positively impacts the ROE of the company.

For example; Company X has revenues of Rs 10000 and average assets of Rs 200. Hence the asset turnover is as follows

Asset Turnover= Revenues/Average Assets = 1000/200 = 5

3. Financial Leverage- This refers to the debt usage to finance the assets. The companies should strike a balance in the usage of debt. The debt should be used to finance the operations and growth of the company. However usage of excess leverage to push up the ROE can turn out to be detrimental for the health of the company.

For example; Company X has average assets of Rs 1000 and equity of Rs 400. Hence the leverage of the company is as

Financial Leverage = Average Assets/ Average Equity= 1000/400 = 2.5

In the example given in the question, the industry average is our benchmark. The new ROI of 12 % is above the industry benchmark of 11 %. As the TAT is constant, the increase in ROI is due to the increase in NPM.

The Net Profit Margin is further broken down into three categories:

• Tax Burden: Net Income/EBT: A higher value for the tax burden implies that the company can keep a higher percentage of its pretax profits, indicating a lower tax rate.
• Interest Burden: EBT/EBIT: Higher the borrowing cost lower would be the ROE.
• EBIT Margin: EBIT/Revenue: This captures the effect of operating margin or EBIT margin on ROE. This ratio measures the effect of operating profitability on ROE.

If there is an increase in the Net Profit Margin without a change in the Financial Leverage, it shows that the company is able to increase its profitability.

But if the company is able to increase it’s ROE only due to increase in Financial Leverage, it’s risky since the company is able to increase its assets by taking debt.

Thus we need to check whether the increase in company’s ROE is due to increase in Net Profit Margin or Asset Turnover Ratio (which is a good sign) or only due to Leverage (which is an alarming signal).

The biggest drawback of the DuPont analysis is that, while expansive, it still relies on accounting equations and data that can be manipulated. Plus, even with its comprehensiveness, the Dupont analysis lacks context as to why the individual ratios are high or low, or even whether they should be considered high or low at all.