8. 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, Madison, stepped into your office and asked the following.
MADISON: 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?
MADISON: 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. Xavier, 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 Xavier 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 |
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---|---|---|---|---|---|
Cash | $1,300,000 | Accounts payable | $1,560,000 | Sales | $26,000,000 |
Accounts receivable | 2,600,000 | Accruals | 520,000 | Cost of goods sold | 13,000,000 |
Inventory | 3,900,000 | Notes payable | 2,080,000 | Gross profit | $13,000,000 |
Current assets | $7,800,000 | Current liabilities | $4,160,000 | Operating expenses | 6,500,000 |
Long-term debt | 6,760,000 | EBIT | $6,500,000 | ||
Total liabilities | $10,920,000 | Interest expense | 1,060,800 | ||
Common stock | 1,170,000 | EBT | $5,439,200 | ||
Net fixed assets | 7,800,000 | Retained earnings | 3,510,000 | Taxes | 1,903,720 |
Total equity | $4,680,000 | Net income | $3,535,480 | ||
Total assets | $15,600,000 | Total debt and equity | $15,600,000 |
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.
Canis Major Veterinary Supplies Inc. DuPont Analysis |
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---|---|---|---|---|---|
Ratios | Value | Correct/Incorrect | Ratios | Value | Correct/Incorrect |
Profitability ratios | Asset management ratio | ||||
Gross profit margin (%) | 50.00 | Total asset turnover | 1.67 | ||
Operating profit margin (%) | 20.92 | ||||
Net profit margin (%) | 22.66 | Financial ratios | |||
Return on equity (%) | 54.01 | Equity multiplier | 1.43 |
MADISON: 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.
Canis Major Veterinary Supplies Inc. DuPont Analysis |
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---|---|---|---|---|---|
Calculation | Value | ||||
Profitability ratios | Numerator | Denominator | |||
Gross profit margin (%) | / | = | |||
Operating profit margin (%) | / | = | |||
Net profit margin (%) | / | = | |||
Return on equity (%) | / | = | |||
Asset management ratio | |||||
Total asset turnover | / | = | |||
Financing ratios | |||||
Equity multiplier | / | = |
MADISON: I see what I did wrong in my computations. Thanks for reviewing these calculations with me. You saved me from a lot of embarrassment! Xavier 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 Canis Major’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.
Decrease the company’s use of debt capital because it will decrease the equity multiplier.
Use more equity financing in its capital structure, which will increase the equity multiplier.
Increase the cost and amount of assets necessary to generate each dollar of sales because it will increase the company’s total asset turnover.
Use more debt financing in its capital structure and increase the equity multiplier.
MADISON: 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.
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14. The DuPont equation Corporate decision makers and analysts often use a technique called DuPont analysis to understand and assess the factors that drive a company’s financial performance, as measured by its return on equity (ROE). Depending on the version used, the DuPont equation will deconstruct the firm’s ROE, its best measure of financial performance, into two or three important factors, or drivers. DuPont analysis can be conducted using either the traditional DuPont equation or the extended DuPont equation. The...