Question

Modified Du Pont System

Integrated Analysis of a Company’s Profitability

LAURA Incorporation (LAR) is a well-established and reasonably successful company in the rather-competitive apparel business, focusing on streetwears. In spite of its outstanding position in its industry (e.g.with the highest number of followers on Instagram and Facebook in comparison to other streetwears merchants/houses), LAR managers wish to assess the firm’s strengths and/or weaknesses for managerial purposes. Details of LAR and its industry are given as follows:

	LAR	Industry
EPS	$ 9.5	$ 5.5
ROE	N/A	12%
Profit Margin	N/A	4%
Total asset turnover	N/A	1
Equity multiplier	N/A	3
Stock price	$ 77	-
# of shares outstanding (shrs) 1,000,000	-	-
Equity book value per share $40	-	-
Sales	$ 70,000,000	-
Total Asset	$ 100,000,000	-

(Note: N/A stands for “not available” and that you need to calculate it.)

Questions:

1) Identify whether investors would be happy with LAR performance based on Modified DuPont System. Identify the firm’s strengths and weaknesses.

2) Provide a suggestion/note to LAR management on how the firm should improve or maintain various aspects of their corporate finance (based on Modified DuPont System) through a 3-page executive summary document. Be insightful and clear as much as possible.

Answer 1

	LAR	Industry
EPS	9.5		5.5
ROE =EPS/Book value per share	9.5/40=	23.75%	12%
Profit Margin =Net Income/Sales---Net income=EPS*No.of shares o/s	(9.5*1000000)/70000000=	13.57%	4%
Total asset turnover= Sales/ Total assets	70000000/100000000=	0.7	1
Equity multiplier=Total assets/Total BV of equity	100000000/(40*1000000)=	2.5	3
Stock price	77
# of shares outstanding (shrs) 1,000,000	1000000
Equity book value per share	40
Sales	70000000
Total Asset	100000000
### Net Income=EPS*No.of shares o/s
!!! Total equity= BV per share*No.of shares o/s

1.Investors would be happy with LAR performance (based on Modified DuPont System)

based on its strengths, ie.

its ROE 23.75% is almost twice that of the industry average of 12%

because of its profit margin which is more than thrice the industry average.

Weakness:

Lesser $ sales generation(0.7) per $ of total assets utilised , than that of the industry (1)

More of equity funding/financing of its assets --as indicated by the lesser EM ratio(2.5 times)than the industry average of 3 times.

2…	PM *	TATO*	EM/FL	=ROE
LAR	13.57%	0.7	2.5	23.75%
Ind. Av.	4%	1	3	12.00%

2. LAR 's high profit margin & ROE despite is its high equity, in its capital structure --is its major strength --indicating its operational efficiency , ie.profitability in regular business operations , meaning control of operating & non-operating expenses, at teh given level of sales.

As per the above table----modified DuPont analysis of the ROE ratio,

it can be disaggregated into 3/ 5 components, namely

ROE=Net Income/Equity= Profit Margin*Total assets Turnover*Equity Multiplier (ie. Financial Leverage)

ie. ROE=(Net Income/Sales)*(Sales/Total assets)*(Total assets/Total equity)

ie. ROE=Profitabilty*Asset utilisation efficiency*Financial Leverage

where Profit Margin* Total assets turnover= Return on Assets

ie. ROE=ROA*Equity multiplier= (Net Income/Total assets)*(Total assets/Total equity)

The point , is when we decompose the ROE, this way, & compare with industry average or with previous year's same counter-part figures, we can clearly fix the area of performance/non-performance.

As we did in 1. above,

LAR is far ahead in ROE & Profit margin the industry average

But as far as utilisation of assets is concerned , in generating sales revenues, the 0.7 ratio indicates that there is scope for improvement ---which when achieved--will boost the ROE further.

Also, the equity multiplier/financial leverage of 2.5 as against 3 of the industry, indicates that introducing some amount of debt in the capital structure , may give tax advantages of the interest expenses on debt --which will also boost the ROE, by reducing the equity proportion , as well. Also the cost of capital will reduce as compared to higher equity capital employed.

Thus, DuPont helps us to see that LAR can improve upon or rather there is scope for improvement of the last two ratios of the identity, ie. Employ sale promotion efforts to increase sales & utilise assets more efficiently--as well as try more debt , in its capital structure , to take advantage of interest tax shields, that creates more value to firm , by retaining some cash within the firm , as also reduces cost of capital--- as equity is the costliest source of financing.