In: Accounting
9. An analysis of company performance using DuPont analysis
A sheaf of papers in his hand, your friend and colleague, Landon, steps into your office and asked the following.
LANDON: 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?
LANDON: I’ve been reviewing the company’s financial statements and looking for ways to improve our performance, in general, and the company’s return on equity, or ROE, in particular. Amelia, 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 whether I’ve missed anything.
Here are the balance sheet and income statement data that Amelia 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 | $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 | 571,200 | ||
Common stock | 980,000 | EBT | 2,928,800 | ||
Net fixed assets | 5,600,000 | Retained earnings | 2,940,000 | Taxes | 1,025,080 |
Total equity | 3,920,000 | Net income | $1,903,720 | ||
Total assets | $9,800,000 | Total debt and equity | $9,800,000 |
If I remember correctly, the DuPont equation breaks down our ROE into three component ratios: thenet profit margin , the total asset turnover ratio, and theequity multiplier .
And, according to my understanding of the DuPont equation and its calculation of ROE, the three ratios provide insights into the company’sshareholder and dividend management , effectiveness in using the company’s assets, andmanagement of its revenues and depreciation methods .
Now, let’s see your notes 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.
Hydra Cosmetics Inc. DuPont Analysis
Ratios |
Value |
Correct/Incorrect |
Ratios |
Value |
Correct/Incorrect |
---|---|---|---|---|---|
Profitability ratios | Asset management ratio | ||||
Gross profit margin (%) | 50.00 | Total assets turnover | 1.43 | ||
Operating profit margin (%) | 20.92 | ||||
Net profit margin (%) | 19.43 | Financial ratios | |||
Return on equity (%) | 46.40 | Equity multiplier | 1.67 |
LANDON: 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:
Do not round intermediate calculations and round your final answers up to two decimals.
Hydra Cosmetics Inc. DuPont Analysis
Ratios |
Calculation |
Value |
|||
---|---|---|---|---|---|
Profitability ratios | Numerator | Denominator | |||
Gross profit margin (%) | / | = | |||
Operating profit margin (%) | / | = | |||
Net profit margin (%) | / | = | |||
Return on equity (%) | / | = | |||
Asset management ratio | |||||
Total assets turnover | / | = | |||
Financial ratios | |||||
Equity multiplier | / | = |
LANDON: I see what I did wrong in my computations. Thanks for reviewing these calculations with me. You saved me from a lot of embarrassment! Amelia 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 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 assets turnover.
Increase the firm’s bottom-line profitability for the same volume of sales, which will increase the company’s net profit margin.
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 interest rate on its notes payable or long-term debt obligations because it will reduce the company’s net profit margin.
LANDON: 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.
Balance Sheet Data | |||
Cash | $ 700,000 | Accounts payable | $ 840,000 |
Accounts receivable | $ 1,400,000 | Accruals | $ 280,000 |
Inventory | $ 2,100,000 | Notes payable | $ 1,120,000 |
Current assets | $ 4,200,000 | Current liabilities | $ 2,240,000 |
Long-term debt | $ 3,640,000 | ||
Total liabilities | $ 5,880,000 | ||
Common stock | $ 980,000 | ||
Net fixed assets | $ 5,600,000 | Retained earnings | $ 2,940,000 |
Total equity | $ 3,920,000 | ||
Total assets | $ 9,800,000 | Total debt and equity | $ 9,800,000 |
Sales | A | $ 14,000,000 | |
Cost of goods sold | B | $ 7,000,000 | |
Gross profit | C=A-B | $ 7,000,000 | |
Operating expenses | D | $ 3,500,000 | |
Operating Profit (EBIT) | E=C-D | $ 3,500,000 | |
Interest expense | F | $ 571,200 | |
EBT | G=E-F | $ 2,928,800 | |
Taxes | H | $ 1,025,080 | |
Net income | I=G-H | $ 1,903,720 | |
Calculation of Equity (J): | $ 3,920,000 | ||
Total Assets (K): | $ 9,800,000 |
Ratios | Calculation | Formula | Value | ||
Profitability ratios | Numerator | Denominator | |||
Gross profit margin (%) | Gross Profit | / | Revenue | C / A | 50.00% |
Operating profit margin (%) | Operating Profit | / | Revenue | E / A | 25.00% |
Net profit margin (%) | Net Profit | / | Revenue | I / A | 13.60% |
Return on equity (%) | Net Income | / | Shareholders Equity | 48.56% | |
Asset management ratio | |||||
Total assets turnover | Revenue | / | Total Assets | A / K | 1.43 |
Financial ratios | |||||
Equity multiplier | Total Assets | / | Total Shareholders Equity | K/J | 2.50 |
Du-Pont Analysis | ||||
Return on Equity (ROE) | = | Net Profit Margin * Total Assets Turnover * Equity Multiplier | ||
= | 13.60 % * 1.43 * 2.50 | |||
= | 48.56% | |||
Du-pont Analysis pin-point the effect of pofitablity, asset turnover and financial leverage. |
Now analye the Situations: |
1) Increase the efficiency of its assets so that it generates more sales with each dollar of asset investment and increases the company’s total assets turnover. |
If company can increase more sales with same assets, the total asset turnover ratio would improve and it would be having postive impact on the return on equity |
2. Increase the firm’s bottom-line profitability for the same volume of sales, which will increase the company’s net profit margin. |
If company can increase the firm's bottom line profitablity, it would improve net profit ratio and it would be having postive impact on the return on equity |
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. |
If company can reduce the firm's operating expenses and interest costs, it would improve net profit ratio and it would be having postive impact on the return on equity |
Increase the interest rate on its notes payable or long-term debt obligations because it will reduce the company’s net profit margin. |
If company increase interest costs, it would reduce the net profit ratio and it would be having negative impact on the return on equity |