Question

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 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 whether 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	$1,000,000	Accounts payable	$1,200,000	Sales	$20,000,000
Accounts receivable	2,000,000	Accruals	400,000	Cost of goods sold	12,000,000
Inventory	3,000,000	Notes payable	1,600,000	Gross profit	8,000,000
Current assets	6,000,000	Current liabilities	3,200,000	Operating expenses	5,000,000
		Long-term debt	4,500,000	EBIT	3,000,000
		Total liabilities	7,700,000	Interest expense	732,000
		Common stock	1,575,000	EBT	2,268,000
Net fixed assets	8,000,000	Retained earnings	4,725,000	Taxes	793,800
		Total equity	6,300,000	Net income	$1,474,200
Total assets	$14,000,000	Total debt and equity	$14,000,000

If I remember correctly, the DuPont equation breaks down our ROE into three component ratios: the net profit margin, the total asset turnover ratio, and the equity multiplier.

And, according to my understanding of the DuPont equation and its calculation of ROE, the three ratios provide insights into the company’s use of debt versus equity financing, effectiveness in using the company’s assets, and control over its expenses.

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 (%)	40.00		Total assets turnover	1.43
Operating profit margin (%)	11.34
Net profit margin (%)	10.53		Financial ratios
Return on equity (%)	27.41		Equity multiplier	1.82

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:

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		/		=

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.

a) Increase the cost and amount of assets necessary to generate each dollar of sales because it will increase the company’s total assets turnover.

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 assets turnover.

c) 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.

d) Decrease the company’s use of debt capital because it will decrease the equity multiplier.

Answer 1

Ratios	Value	Correct/Incorrect	Ratios	Value	Correct/Incorrect
Profitability ratios			Asset management ratio
Gross profit margin (%)	40	Correct	Total assets turnover	1.43	Correct
Operating profit margin (%)	11.34	Incorrect
Net profit margin (%)	10.53	Incorrect	Financial ratios
Return on equity (%)	27.41	Incorrect	Equity multiplier	1.82	Incorrect

Please see the explanation below. Values have been worked out in the table below:

Ratios		Calculation		Value
Profitability ratios	Formula	Numerator		Denominator
Gross profit margin (%)	Gross Profit / Sales	8,000,000	/	20,000,000	40.00
Operating profit margin (%)	EBIT / Sales	3,000,000	/	20,000,000	15.00
Net profit margin (%)	Net income / Sales	1,474,200	/	20,000,000	7.37
Return on equity (%)	Net income / Total Equity	1,474,200	/	6,300,000	23.40
Asset management ratio
Total assets turnover	Sales / Total assets	20,000,000	/	14,000,000	1.43
Financial ratios
Equity multiplier	Total assets / Total Equity	14,000,000	/	6,300,000	2.22

You can cross check the ROE as = Net profit margin (%) x Total assets turnover x Equity multiplier = 7.37 x 1.43 x 2.22 = 23.40 (Same as that calculated by direct formula)

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Multiple choice question:

Following two answers are correct. Please select them:

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 assets turnover.

c) 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.

Point (b) increases total asset turnover and (c) improves net profit margin. Both the factgors will enahve the ROE.