Question

10. An analysis of company performance using DuPont analysis

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

CHLOE: 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?

CHLOE: 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. Eric, 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 Eric 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	$600,000	Accounts payable	$720,000	Sales	$12,000,000
Accounts receivable	1,200,000	Accruals	240,000	Cost of goods sold	7,200,000
Inventory	1,800,000	Notes payable	960,000	Gross profit	$4,800,000
Current assets	$3,600,000	Current liabilities	$1,920,000	Operating expenses	3,000,000
		Long-term debt	2,400,000	EBIT	$1,800,000
		Total liabilities	$4,320,000	Interest expense	403,200
		Common stock	720,000	EBT	$1,396,800
Net fixed assets	3,600,000	Retained earnings	2,160,000	Taxes	488,880
		Total equity	$2,880,000	Net income	$907,920
Total assets	$7,200,000	Total debt and equity	$7,200,000

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.

CHLOE: 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.

CHLOE: I see what I did wrong in my computations. Thanks for reviewing these calculations with me. You saved me from a lot of embarrassment! Eric 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 Hydra’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.

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.

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

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.

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

CHLOE: 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

Return on equity (ROE) can be formulated as multiplication of net profit margin, asset turnover ratio and equity multiplier using dupont analysis

Net profit margin tells you the operational effeciency of a company. The higher the margin, the better company able to make profits from sales by controlling the costs.

Asset turnover ratio tells you the assets efficiency of a company. Higher the multiple, the better the company is exploiting its assets to generate sales. In a way, the total assets are more of a productive assets.

Equity multiplier tells you the leverage of a company.Company should also depend on the debt, not just constrain to the equity for its funding activities because cost of equity is higher than debt. Higher the multiple, higher the assets that are funded by debt. Companies should also be careful to use their debt contribution in the total capital structure.

Workings are done below: