Question

Consider the following two companies and the operating decisions they have made over a five –year period:

COMPANY B 2002 2003 2004 2005 2001 119.3 In Thousand Dollars Net Income Sales Total Assets 125 1122 13601620 1890 1001.61001.6 1001.6 1001.6 1001.6 656 23 120 122 123 656 656 656 656 Book Value of Equity Family living withdrawals 23 23 23 23 COMPANY C 2001 2002 2003 2004 2005 189 In Thousand Dollars 150 173 119.3 126 Net Income Sales Total Assets 941.5 1000 1080 1240 1340 1001.61080 1180 13551475 656 40 656 656 656 656 Book Value of Equity Family living withdrawals ratio 23 25 30 35

1.Perform a DuPont analysis and compare the results. How do these companies operating and financial decisions differ from each other?

2.Calculate the companies’ sustainable growth rates and the corresponding sustainable growth challenge for each year. What operating and financial strategies can you recommend to attain balanced growth, whenever such goal is not attained?

Answer 1

Sol 1: The DuPont Analysis of the two companies have been worked as under and by comparing the results it is deduced that Company C has improved its Net Profit Margin over the year which in turn has led to improved Return on Equity when compared with Company B.

	Dupont Analysis Company B								Dupont Analysis Company C
a	Net Profit Margin= Net Income / Sales	12.67%	10.70%	8.97%	7.59%	6.61%		a	Net Profit Margin= Net Income / Sales	12.67%	12.60%	13.89%	13.95%	14.10%
b	Asset Turnover Ratio = Sales / Total Assets	0.94	1.12	1.36	1.62	1.89		b	Asset Turnover Ratio = Sales / Total Assets	0.94	0.93	0.92	0.92	0.91
c	Financial Leverage= Total Assets / Total Equity	1.53	1.53	1.53	1.53	1.53		c	Financial Leverage= Total Assets / Total Equity	1.53	1.65	1.80	2.07	2.25
	Dupont Formula (Return on Equity) = a*b*c	18.19%	18.29%	18.60%	18.75%	19.05%			Dupont Formula (Return on Equity) = a*b*c	18.19%	19.21%	22.87%	26.37%	28.81%

Company B and Company C operations can be scrutinized by looking at their Net Profit Margin & Asset Turnover Ratio. Here we can see that Company B is not improving its operational efficiency with the increase in Sales as the Net Profit Margin is decreasing YoY on the other hand Company C has maintained a stable Net Profit margin in initial years which it increased in last year. This shows that Company C is focused on not letting the Margins dip by improving operational efficiency. However if we look at the Asset Turnover Ratio company B has shown an overall YoY increase in this ratio. This means that since they have not added any assets over the year and with increase Sales they have improved this turnover. Company C on the other hand had added to its total assets every year and with moderate increase in Sales had maintained this Turnover too i.e. not overly indulged in buying assets.

Coming to the Financial Leverage Ratio here again Company B have been static on one ratio as it has neither induced any Asset not increased its share equity. On the other hand Company C is looking slightly more leveraged but with other ratios of Net Profit Margin improving and Asset Turnover not declining alarmingly we can accept slight leverage to improve Return on Equity which is clearly favoring the tactics used by Company C.

Sol 2. Companies Sustainable growth rate can be calculated using the formula:-

Company B Sustainable Growth Rate								Company C Sustainable Growth Rate
		2001	2002	2003	2004	2005				2001	2002	2003	2004	2005
	Net Income	119.3	120	122	123	125			Net Income	119.3	126	150	173	189
	Family Living Withdrawals	23	23	23	23	23			Family Living Withdrawals	23	25	30	35	40
	Retained Earning	96.3	97	99	100	102			Retained Earning	96.3	101	120	138	149
	Retained Earning %	80.72%	80.83%	81.15%	81.30%	81.60%			Retained Earning %	80.72%	80.16%	80.00%	79.77%	78.84%
	Dupont Formula (Return on Equity)	18.19%	18.29%	18.60%	18.75%	19.05%			Dupont Formula (Return on Equity)	18.19%	19.21%	22.87%	26.37%	28.81%
	Sustainable Growth Rate = Retained Earning % *Return on Equity	14.68%	14.79%	15.09%	15.24%	15.55%			Sustainable Growth Rate = Retained Earning % *Return on Equity	14.68%	15.40%	18.29%	21.04%	22.71%

To attain a balance growth rate the company retention rate and return on equity should move in tandem then only the growth rate can be balanced. This suggests that if Return of Equity is improving the Retention Ratio should also improve other wise the company had to grow at a rate which sustaining in the long run cannot be met.