DuPont Analysis

10 Key excerpts on "DuPont Analysis"

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  eBook - PDF

  Essentials of Corporate Finance

  • Robert Parrino, David S. Kidwell, Thomas Bates(Authors)
  • 2013(Publication Date)
  • Wiley

    (Publisher)

  An Overview of the DuPont System The DuPont system of analysis is a diagnostic tool that uses financial ratios to evaluate a com- pany’s financial health. The process has three steps. First, management assesses the company’s financial health using the DuPont ratios. Second, if any problems are identified, management corrects them. Finally, management monitors the firm’s financial performance over time, look- ing for differences from ratios established as benchmarks by management. Under the DuPont system, management is charged with making decisions that maximize the firm’s return on equity as opposed to maximizing the value of the stockholders’ shares. The system is primarily designed to be used by management as a diagnostic and corrective tool, though investors and other stakeholders have found its diagnostic powers of interest. The DuPont system is derived from two equations that link the firm’s return on assets (ROA) and return on equity (ROE). The system identifies three areas where management should focus its efforts in order to maximize the firm’s ROE: (1) how much profit management can earn on sales, (2) how efficient management is in using the firm’s assets, and (3) how much financial leverage management is using. Each of these areas is monitored by a single ratio, and together the ratios comprise the DuPont equation. The ROA Equation The ROA equation links the firm’s return on assets with its total asset turnover and net profit margin. We derive this relation from the ROA equation as follows: ROA 5 Net income Total assets LEARNING OBJECTIVE 4 104 CHAPTER 4 I Analyzing Financial Statements 5 Net income Total assets 3 Net sales Net sales 5 Net income Net sales 3 Net sales Total assets 5 Net profit margin 3 Total asset turnover As you can see, we start with the ROA formula presented earlier as Equation 4.18. Then we multiply ROA by net sales divided by net sales.

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  Fundamentals of Corporate Finance

  • Robert Parrino, David S. Kidwell, Thomas Bates, Stuart L. Gillan(Authors)
  • 2021(Publication Date)
  • Wiley

    (Publisher)

  However, the group of ratios presented in this chap- ter is a fair representation of the ratios needed to analyze the performance of a business. When using ratios, it is important that you ask yourself, “What does this ratio mean, and what is it measuring?” rather than trying to memorize a definition. Good ratios should make good eco- nomic sense when you look at them. Before You Go On 1. What are the efficiency ratios, and what do they measure? Why, for some firms, is the total asset turnover more important than the fixed asset turnover? 2. List the leverage ratios discussed in this section, and explain how they are related. 3. List the profitability ratios discussed in this section, and explain how they differ from each other. LEARNING OBJECTIVE 4. Describe the DuPont system of analysis and be able to use it to evaluate a firm’s performance and identify corrective actions that may be necessary. By now, your mind may be swimming with ratios. Fortunately, some enterprising financial managers at the DuPont Company developed a system that ties together some of the most important financial ratios and provides a systematic approach to financial ratio analysis. An Overview of the DuPont System The DuPont system of analysis is a diagnostic tool that uses financial ratios to evaluate a company’s financial health. The process has three steps. First, management assesses the company’s financial health using the DuPont ratios. Second, if any problems are iden- tified, management corrects them. Finally, management monitors the firm’s financial performance over time, looking for differences from ratios established as benchmarks by management. Under the DuPont system, management is charged with making decisions that maxi- mize the firm’s return on equity as opposed to maximizing the value of the stockholders’ shares.

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  Fundamentals of Healthcare Finance, Fourth Edition

  • Paula H. Song, Kristin L. Reiter(Authors)
  • 2022(Publication Date)
  • Gateway to Healthcare Management

    (Publisher)

  Financial ratio analysis provides a great deal of information about a business’s financial condition, but it does not provide an overview, nor does it tie any of the ratios together. DuPont Analysis provides an overview of a business’s financial condition and helps managers and investors understand the relationships among several ratios (see “Critical Concept: DuPont Analysis”).

  DuPont Analysis, so named because managers at the DuPont Company developed it, combines basic financial ratios in a way that provides valuable insights into a business’s profitability. The analysis breaks down return on equity, perhaps the most important measure of profitability (at least for for-profits), into the product of three other ratios, each of which has an important economic interpretation. The result is the DuPont equation:

  ROE	=	Total margin × Total asset turnover × Equity multiplier
  =	Net income ÷ Total revenue × Total revenue ÷ Total assets ×
  Total assets ÷ Total equity.

  Again, we use Park Ridge Home Care’s 2021 data to illustrate the DuPont equation. We have also included the peer group average DuPont equation for later comparison. (Note that the ratios used in the analysis are rounded to the nearest tenth of a percent, so the multiplication results are not exact. Also, the peer group averages in the following DuPont Analysis differ slightly from the peer group averages presented previously because the equation represents the average home health care business’s value on all four ratios, while the values presented previously reflect the averages when the ratios are considered independently.)

  Park Ridge Home Care ROE = 34.1% = 4.0% × 3.3 × 2.6.      Peer group average ROE = 36.5% = 5.9% × 2.2 × 2.8.

  In the DuPont equation, the product of the first two terms on the right side is return on assets, so the equation can also be written as ROE =ROA × Equity multiplier. Park Ridge’s 2021 total margin was 4.0 percent, so the business made a 4.0 cent profit on each dollar of total revenue. Furthermore, assets were turned over (or created revenues) 3.3 times during the year, so the business earned a return of 4.0% × 3.3 = 13.2% on its assets. This value for ROA is the same as was calculated previously in our ratio analysis discussion (13.4 percent) except for a rounding difference.

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  Analysis of Financial Statements

  • Pamela Peterson Drake, Frank J. Fabozzi(Authors)
  • 2012(Publication Date)
  • Wiley

    (Publisher)

  In a similar manner, we can restate each balance sheet item as a percentage of total assets and then make year-to-year comparisons. Examining changes in the asset composition tells us about how the company is altering its investments; examining changes in the liabilities and equity tells us about how the company is altering its capital structure.

  INTEGRATED RATIO ANALYSIS Financial analysis requires pulling together many pieces of information. Analysis of a company requires gathering information that includes:

  • A description of the company, including its line(s) of business, and major corporate events, such as acquisitions and divestitures.
  • The industry or industries in which it operates and its major competitors.
  • Major factors (e.g., economic, competitive, or legal) that have affected the company in the recent past and may affect the company going forward.
  • Relevant financial ratios for at least the past 5 years, but preferably the past 10 years.
  • Common-size analysis over the past 5 to 10 years.

  A thorough analysis of a company would require more space than we can allow here, but we can present the basic financial ratio analysis and common-size analysis. We use DuPont as an example, using published annual financial data.

  Company Description, Industry, and Major Factors

  E. I. DuPont De Nemours and Company is a company's whose main business line is chemicals, but the company has a significant investment in agriculture and biotechnology, and considers itself to be a science and technology focused company. We provide a breakdown of DuPont's revenues by reported segment in Exhibit 4.17 .

  EXHIBIT 4.17 DuPont's 2010 Revenues by Segments, in Billions

  Source of data : DuPont, 2010 10-K filing.

  Its Industry

  DuPont's primary line of business is chemicals, but it could very well be described as a conglomerate because of its lines of business extending into agriculture (e.g., seeds), electronics (e.g., cell phone displays) and safety and protection, with well-known products including Teflon, Corian, and Kevlar.

  If we look at the chemical industry globally, we see that DuPont is a significant U.S. participant in this industry, but the industry is dominated by Exxon Mobil, which is an oil and gas company with significant specialty chemical and research segments. We provide a breakdown of the industry by the major players in Exhibit 4.18

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  Financial Accounting

  The Basics

  • Ilias Basioudis(Author)
  • 2019(Publication Date)
  • Routledge

    (Publisher)

  The DuPont Analysis computes the ROE as the product of margin, volume/turnover, and leverage. DuPont Analysis breaks ROE into its constituent components to determine which of these components is most responsible for changes in ROE.

  R O E = N e t p r o f i t m a r g i n × T o t a l a s s e t t u r n o v e r × E q u i t y m u l t i p l i e r

  The equity multiplier, as shown below, is a measure of the business’s leverage. We can rewrite the DuPont relationship using the ratio formulas as follows:

  R O E =

  N e t   I n c o m

  e ⋆

  S a l e s

  ×

  S a l e s

  T o t a l   a s s e t s

  ×

  1

  1 −

  t o t a l   l i a b i l i t i e s

  t o t a l   a s s e t s

  *In some textbooks, net income in the equation above refers to the income before interest and tax, and elsewhere, to the income that remains after subtracting all operating expenses, taxes, interest, and preferred share dividends from a company’s total revenue.

  By using the above DuPont equation, users can determine whether operating efficiency, asset use efficiency, or leverage is most responsible for ROE variations.

  There is nothing mystical about the above equation. With a little algebra, it collapses to net income divided by equity, which is just the equation for ROE. However, it is extremely useful as a tool to establish a beginning point for analysis. Whether the ROE is declining, or not as high as the company’s competitors, determines if the problems are with the margin, volume, or leverage of the company. Note that high leverage may mask problems with margin and volume/turnover.

  Once you have located the problem, examine the inputs to the troublesome ratio for additional clues. For example, if total asset turnover is declining, is it because sales have dropped or because the business has acquired additional assets? The ratios will provide flags that prompt further investigation and possibly generate new, more probing questions.

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  Analysis of Financial Statements

  • Frank J. Fabozzi, Pamela P. Peterson(Authors)
  • 2012(Publication Date)
  • Wiley

    (Publisher)

  The DuPont system was developed by E. I. du Pont Nemours as a means of relating the company’s performance to specific aspects of the management of the company. In its simplest form, this system is a method of breaking down the return ratio into its profit margin and turnover components. Suppose the return on assets changes from 20% to 10%. We do not know whether this decreased return is due to a less efficient use of the company’s assets—that is, due to lower activity—or to lower profit margins. A lower return on assets could be due to lower activity, lower margins, or both. Because we are interested in evaluating past operating performance to evaluate different aspects of the management of the company or to predict future performance, knowing the source of these returns is valuable information. The DuPont system allows us to breakdown the return ratios into components, identifying the sources of the changes in returns.

  For example, we can breakdown the operating return on assets and the return on assets both into two components, margin and turnover:10

  EXHIBIT 4.11 The DuPont Breakdown of the Return on Assets

  By looking at the components, turnover and profit margin, and their changes from year to year, we get a better idea of what is behind changes in returns from year to year. Similarly, the return on shareholders’ equity can be broken down into three components:

  The task of breaking down ratios into components can be performed on any return ratio and can reduce the ratios to their smallest components. For example, the return on equity can be broken down into five components: asset turnover, operating profit margin, fixed financial charge burden, tax burden, and financial leverage, as we demonstrate in Exhibit 4.12 .

  EXHIBIT 4.12 The Return on Equity for Pfizer, Inc. for 2004, Broken Down in Components Using the DuPont System

  We can use the DuPont system to diagnose the source of change in returns over time. Consider Winn-Dixie prior to its bankruptcy filing in February 2005. We graph its total asset turnover, profit margin, and return on assets for the 15 years leading up to bankruptcy, as we show in Exhibit 4.13

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  Financial Analysis with Microsoft Excel

  • Timothy Mayes(Author)
  • 2020(Publication Date)
  • Cengage Learning EMEA

    (Publisher)

  DuPont Analysis The ROE is important to both managers and investors. The effectiveness of managers is often measured by changes in ROE over time, and their compensation may be tied to ROE-based goals. Therefore, it is important that they understand what they can do to improve the firm’s ROE and that requires knowledge of what causes changes in ROE over time. For example, we can see that EPI’s return on equity dropped precipitously from 2019 to 2020. As you might imagine, both investors and managers are probably trying to figure out why this happened. The DuPont system is one way to look at this problem. The DuPont system is a way to break down the ROE into its components so that man- agement can understand how to improve the firm’s ROE. Let’s first take another look at the ROA: ROA 5 Net Income Total Assets 5 Net Income Sales 3 Sales Total Assets (3-24) So, the ROA shows the combined effects of profitability (as measured by the net profit margin) and the efficiency of asset usage (the total asset turnover). Therefore, ROA could be improved by either increasing profitability or by using assets more efficiently. As mentioned earlier, the amount of leverage that a firm uses is the link between ROA and ROE. Specifically: ROE 5 Net Income Equity 5 Net Income Total Assets 3 Total Assets Equity (3-25) Note that the second term in (3-25) is sometimes called the “equity multiplier” and from (3-13) we know it is equal to: Total Assets Total Equity 5 1 1 2 Total Debt Ratio 5 1 1 2 Total Debt Total Assets (3-26) Copyright 2021 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. Due to electronic rights, some third party content may be suppressed from the eBook and/or eChapter(s). Editorial review has deemed that any suppressed content does not materially affect the overall learning experience. Cengage Learning reserves the right to remove additional content at any time if subsequent rights restrictions require it.

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  Agricultural Finance

  • Charles B. Moss, Charles Moss(Authors)
  • 2013(Publication Date)
  • Routledge

    (Publisher)

  The DuPont Corporation was one of the first conglomerates (see the E.I. du Pont de Nemours – Company History box). Conglomerations are companies that own other companies (typically by purchasing the controlling issues in other corporations). In carrying out its conglomeration efforts, the DuPont corporation developed a methodology for evaluating the potential of firms using ratio analysis which has become known as the DuPont Analysis. While this approach was pioneered for corporate use, the DuPont system is frequently used to analyze sole proprietorships (Melvin et al., 2004) and agriculture (Mishra et al., 2009). E.I. du Pont de Nemours – Company History E.I. du Pont de Nemours & Company is undoubtedly better known by consumers under the moniker DuPont, the oldest family name in American preindustrial wealth. Its reputation is synonymous with organic chemistry. Founded in 1802, the company began as a partnership in gunpowder and explosives. DuPont grew from a family business to a multinational conglomerate through the acquisition of competing companies and through the diversification of product lines. As of 1998 the company operated 30 petroleum refineries and natural gas processing plants through its Conoco subsidiary and 135 manufacturing and processing facilities throughout the world that produced chemicals, synthetic fibers, polymers, and biotech products for a number of different industries. (FundingUniverse, 2012) This chapter develops both the DuPont approach to ratio analysis and common valued financial statements as tools for the analysis of the farm business. Using the DuPont approach, operators can use the financial statements to assess the performance of the farming operation across at least five different areas of performance: profitability, asset management, firm growth, solvency, and liquidity. The most important of these performance measures is profitability

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  Data Analytics for Internal Auditors

  • Richard E. Cascarino(Author)
  • 2017(Publication Date)
  • Auerbach Publications

    (Publisher)

  252 DATA ANALYTICS FOR INTERNAL AUDITORS as management’s attempts to display a specifc impression within the fnancial statements themselves. Horizontal Analysis Horizontal analysis involves the use of comparative fnancial state-ments to calculate dollar or percentage changes in the specifc item in the statement from one period to the next. For example, by look-ing at comparative balance sheets, the current year’s fgure may have the previous year’s fgure subtracted to give the dollar change. Te same could be done for the stockholders’ equity section or the income statement. Anomalies can be detected, such as sales increasing by a given percentage while net income decreases by a higher percent-age. Further examination may indicate cost of goods sold increasing as well as operating expenses, and the auditor may then determine whether these increases are sufcient to more than ofset the increase in sales resulting in an overall decrease in net income. Vertical Analysis Within a single fnancial statement, each individual item is expressed as a percentage of a signifcant total, for example, expressing all income statement items as a percentage of sales. Once again, these can be compared to previous years using a trend analysis. DuPont Analysis Te DuPont method is used to analyze a frm’s return on equity by decomposing it into three parts: • Proftability • Efciency • An equity multiplier Te equity multiplier is intended to represent the efect of the orga-nization’s use of debt fnancing on its return on equity. As the organi-zation uses more debt, the equity multiplier increases, thus ROE profitability = × efficiency × equity multiplier

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  Introduction to Finance

  Markets, Investments, and Financial Management

  • Ronald W. Melicher, Edgar A. Norton(Authors)
  • 2020(Publication Date)
  • Wiley

    (Publisher)

  LO 14.7 Changes in a ratio over time are caused by relative changes in the ratio’s numerator and denominator and their components. Finan- cial analysis does not stop with the calcula- tion of a ratio. Changes in ratios over time or difference in ratios between firms should be explained. DuPont Analysis is one tool for examining return on assets (ROA) or return on equity (ROE). Changes in the ROA occur because of changes in the profit margin and/ or total asset turnover. Changes in ROE occur because of changes in the profit margin, total asset turnover, financial leverage, or some combination of these. DuPont Analysis is valuable for helping to answer the question “Why?” a profitability measure rose or fell from one period to the next or relative to a competitor. LO 14.8 Financial planning uses the financial state- ment relationships to estimate future asset and financing needs. The percent-of-sales methods use the relationship between balance sheet accounts and sales to estimate future asset needs. Combining a sales fore- cast, profit margin, and dividend policy, man- agers can estimate the increase in retained earnings that will provide internally gener- ated financing. The difference between the SUMMARY 460 CHAPTER 14 Financial Analysis and Long-Term Financial Planning forecasted increase in assets and the inter- nally generated financing (such as additions to retained earnings and spontaneous current liability growth) equals the external financing the firm needs to plan to raise. LO 14.9 Cost–volume–profit indicates how profits rise with quantity sold. Operating income equals sales revenue minus total variable costs minus fixed costs. Profits can be esti- mated given a sales forecast. In addition, the break-even quantity can be measured using product price, variable cost per unit, and fixed costs.

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