DuPont Analysis

DuPont Analysis – A Significant Measure For Investment Decisions

The proponents of DuPont analysis believe that ‘measuring assets at ‘ gross value’ removes the incentive to avoid investing in new assets.

Explanation

During 1970s DuPont Corporation used a performance measurement different from the common measurement applied by business enterprises for measuring their investment projects. The purpose of adopting this method was to define ROE based on different components that affect it. As opposed to the simplest way of calculating ROE, DuPont’s multi-faceted calculation was better able to detect whether and where a company had financial leverage.

As per the proponents of this measure, ROE is affected by three important components that are considered under this method. They are as follows:

  1. Operating efficiency which is measured by profit margin.
  2. Asset use efficiency which is measured by total assets turnover.
  3. Financial leverage which is measured by the equity multiplier.

Here,

DuPont-Analysis-Important-Components

By breaking the ROE into three distinct parts, investors can examine how effectively the enterprise is using its equity.

Dupont Analysis in Original Form

New asset avoidance can occur as financial accounting depreciation methods artificially produce lower ROEs in the initial year that an asset is placed into service. If an ROE is unsatisfactory, the DuPont analysis helps to locate the part of the business that is underperforming. Thus, DuPont Corporation’s measure gained importance and has become a popular measure to calculate ROE.

The theoretical concept behind this analysis is that forms of ROE using net book value discourage investment in view potentially risky ventures, because they underestimate the return for the first few years of investment. The DuPont calculation attempts to remedy this situation. By breaking the ROE into profit margin, asset turnover and leverage factor, investors can examine how effectively a company is using equity. This is because poorly performing components will drag down the overall figure.

To calculate ROE through DuPont analysis, multiply the profit margin, assets higher is the return on equity. The below table gives the DuPont financial components of the DuPont model.

ROE = Profit margin x Asset turnover x Equity multiplier

ROE-Calculation

Table (A) DuPont Financial Analysis Model

Income Statement Balance Sheet Return on Capital Employed (ROCE)
Performance measure is: Performance Measure is:
Profitability Activity Profitability x Activity

Table (B) Financial Components of DuPont Model

Profitability Activity Return on Capital Employed (ROCE)
  • Efficiency of the income statement
  • Efficiency of the balance sheet
  • ROCE is a dynamic measurement that integrates the activities of the profit and loss and balance sheet in the calculation.
  • Profitability
  • Activity
  • ROCE = Profitability x Activity
  • = Sales / Total Net Assets
  • = (EBIT / Sales) x (Sales / Total Net Assets)
  • = EBIT / TNA
  • Profitability measurement:  Represents the operating performance of a business enterprise expressed as return on sales. It also provides a measurement of operational efficiency in the profit and loss account, void of finance costs.
  • Activity measurement: Reflects balance sheet efficiency in terms of utilization of scarce resources.
  • ROCE: It provides a measurement of the operational return on the measurement in Total Net Assets (TNA) or Return on Investment (ROI) due to equivalence concept derived from separating finance from operations. ROCE would have to at least equal the average weighted cost of borrowing to avoid reverse leverage taking place. This is the erosion of equity as a result of too little EBIT being generated to service the cost of borrowing

The utility of DuPont Analysis

  • Profit margin indicates how efficient the company’s management is in operating the company and in controlling costs.
  • Assets turnover measures the efficiency of the company in generating sales for every dollar of asset.
  • The equity multiplier shows how leveraged a company is by computing how much financing stockholders provided for every dollar of asset.
  • It is considered a useful tool in predicting future changes in Return on Net Operating Assets (RNOA).
  • It facilitates industry group comparison as a standard measure provided the industry groups use the same measure.
  • It is an approach to analyze the enterprise by evaluating inter-relationships among many of the performance measures.
  • It helps to find out what are the factors that are causing the profit to move up.
  • By identifying these factors, one can try to improve the efficiency of the enterprise.

Merits

  • Using DuPont analysis in evaluating alternative stock investments investors can compare why ROEs of these stocks differ. This they do by identifying the impact of ‘operating efficiency’. ‘asset use efficiency’ and ‘ financial leverage’ on return on equity.
  • The DuPont analysis helps to analyse what contributed to the differing ROEs of stocks that are compared to decide on investment portfolio.
  • DuPont analysis as a tool is a measure of investment portfolio. Instead of using this measure as an isolated measure if used along with other tools such as return on investment, cash flow as percentage of sales (or any other income statement item), etc., the result of analysis will be fantastic.

Limitations

DuPont analysis has certain limitations also. These are as follows:

  • It is a before tax measurement of short-term nature.
  • It does not link to the cost of capital, to the time value of money, and to the value itself.
  • It is difficult to set a target for good ROCE.
  • Using gross value of assets as a measure, instead of net value is contradictory to accounting practice based on principles and standards.

Exhibit

Chart showing the data used to calculate all the ratios used in DuPont analysis. The data presented is the comparative data of TVS and Bajaj for three years.

DuPont-Analysis-Definition-Explanation-Merits-Examples

Analysis

  • TVS has a lower ROCE mainly because of low operating profit (PBIT) and comparatively higher capital employed. This has been the trend for the past three years when TVS was trying to expand. Hence it incurred more cost on it. As a result its non-trade investment is quite low as compared to other competitors who have been operating in the market for quit a long time.
  • PBIT/Sales is less for TVS mainly because of higher EXP/Sales as compared to the industry average.
  • Sales/TA of TVS is more than the industry average mainly because of lower total assets, which in turn is due to lower current assets.
  • Sales/CA is also quite high for TVS as compared to that of Bajaj mainly because of lower amounts of ‘Other CA’ and ‘Loans and ADV’, or in other words, huge Sales/Other CA and Sales/Loans and ADV.
  • As explained earlier, capital employed of TVS is low mainly because it has low net worth and it has raised lower amount of long-term loans when compared with Bajaj.

DuPont analysis as a method of performance measurement has gained importance and is being used as a method to ascertain higher return on equity. By using the gross book value of assets (instead of net book value), the method is able to encourage investment in new, potentially risky ventures, by estimating return on investment appropriately. One of the major merits of DuPont analysis is that it decomposes return on net operating assets (RNOA) into two multiplicative components, profit margin and asset turnover, both of which are largely driven by industry membership. The components used in this analysis being informative facilitate industry data-adjusted comparison which helps in predicting future changes in RNOA. This analysis, if used along with ratios relating to investors analysis or market strength analysis, help investors or potential investors analysis or market strength analysis, help investors or potential investors to make a proper decision on investment portfolio.

Example of DuPont Analysis

Now HERE company Ltd presents the following information for the year 2019-20.

  • Earnings before Interest and Tax (EBIT) $1,200,000,
  • Net sales $9,600,000,
  • Net Assets $6,500,000,
  • Gross Assets $7,000,000,
  • Equity share capital (shares of $10 each) 5,000,000.

You are required to ascertain:

    1. operating efficiency
    2. asset use efficiency, and
    3. financial leverage under
      • DuPont’s analysis
      • traditional analysis
      • compare the result and draw inference from the viewpoint of a potential investor.

Solution

Practical-example-with-solution

(i) Under the traditional method, net assets turnover is taken into account.

(ii) The assets use efficiency under gross total assets is 1.371, whereas under net total assets it is 1.476. These results justify that the use of gross book value of assets removes the incentive to avoid investing in new assets.

(iii) ROE measure EBIT divided by Total stockholders equity fails to analyze the role of operating activity, asset use, and financial leverage. But DuPont’s analysis clearly shows the role of each component in ROE.

Modified DuPont Model

In modified DuPont analysis, the enterprise’s operating decisions are taken care of by operating profit margin (EBIT / Sales) and capital turnover (Sales / Invested capital). The financing decisions are taken care of by financial cost ratio (EBIT / EBIT) and financial structure ratio (Invested Capital / Equity). Even the incidence of business taxation is taken care of by tax effect ratio (EAT / EBT). The relationship that ties these five ratios together is that ROE is equal to their combined product.

Finger Tips

  • ROE is the most comprehensive measure of the profitability of the enterprise.
  • It considers the operating and investing decisions made as well as financing and tax-related decisions.
  • The model dissects ROE into five easily computed ratios that can be examined for potential strategies for improvement.
  • It serves as an efficient tool for decision-makers (say, owners, managers, consultants, and others) for evaluating an enterprise and making recommendations for improvement.

In 1999, Hawawini and Viallet offered a modification to DuPont’s model. This modification resulted in five different ratios that combine to from ROE. They were of the opinion that financial statements that enterprises prepare for their annual reports are not always useful to managers making operating and financial decisions. Therefore, Hawawini and Viallet restructured the traditional balance sheet into a managerial balance sheet, which is a more appropriate tool for assessing the contribution of operating decisions to the enterprise’s financial performance. This restructured balance sheet uses the concept of ‘invested capital’ in place of total assets and the concept of ‘capital employed’ in place of total liabilities and owner’s equity found on the traditional balance sheet.

The primary difference is in the treatment of ‘short-term working capital account’.

The managerial balance sheet uses a net figure called working capital requirement as a part of invested capital (this is determined receivables + inventories + prepaid expenses minus accounts payable + accrued expenses).

The modified DuPont model is constructed as follows:

Modified-DuPont-Model

where,

invested capital = cash + working capital requirement + net fixed assets.

This model still maintains the importance of the impact of operating decisions (i.e., profitability and efficiency) and financing decisions (leverage) upon ROE, but uses a total of five ratios to uncover what drives ROE and gives insight as to how to improve this important ratio.

To improve ROE, one has to increase operating profits, become more efficient in using existing assets to generate sales, better use of debt, and control the cost of borrowing or find ways to reduce tax liability of the enterprise. Each of these choices leads to a different financial strategy. The five ratios combination model suggests better options to the decision-maker.

Exhibit

The below exhibit makes us understand how modified DuPont’s model works.

Income Statement

Income-Statement-DuPont-Analysis

Balance Sheet

Balance-Sheet-Exhibit-Modified-DuPont-Model

Computation of ROE

1. Operating Profit Margin

= EBIT / Net Sales = $118,944 / $2,300,970 = 0.571

2. Capital Turnover

= Net Sales / Invested Capital = $2,300,970 / $1,233,000 = 1.866

3. Financial Cost Ratio

= Earnings before taxes / Earning before interest and taxes = $81,603 / $118,944 = 0.6861

4. Financial Structure

= Invested capital / Owner’s equity = $1,233,000 / $557,100 = 2.2132

5. Tax Effect Ratio

= Earnings after tax / Earings before tax = $57,603 / 81,603 = 0.7059

ROCE = 0.517 x 0.6861 x 2.1232 x 0.7059 = 0.1034 or 10.34%

Invested Capital = Cash + Working Capital + Net Fixed Assets

Working Capital = [(PP Expenses + Accounts Receivable + Inventory) – (Creditors + Accrued Expenses)]

Working Capital = [($36,000 + $555,000 + $600,000) – ($615,000 + $138,000)]

Working Capital = $1,191,000 – $753,000 = $438,000

Cash = $120,000 and Net Fixed Assets = $675,000

Therefore,

Invested Capital = Cash ($120,000) + WC ($438,000) + Net Fixed Assets ($675,000) = $1,233,000)

Note: It is the same as conventional computation of ROCE.

= Earnings after tax / Owner’s equity

= $57,603 / $557,100 = 10.34%

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