Question

An analysis of company performance using DuPont analysis

A sheaf of papers in her hand, your friend and colleague, Ashley, steps into your office and asked the following.

ASHLEY: 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?

ASHLEY: I’ve been reviewing the company’s financial statements and looking for ways to improve our performance, in general, and the company’s return on equity, or ROE, in particular. Mikel, 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 whether I’ve missed anything.

Here are the balance sheet and income statement data that Mikel 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
Cash	$900,000	Accounts payable	$1,080,000	Sales	$18,000,000
Accounts receivable	1,800,000	Accruals	360,000	Cost of goods sold	10,800,000
Inventory	2,700,000	Notes payable	1,440,000	Gross profit	7,200,000
Current assets	5,400,000	Current liabilities	2,880,000	Operating expenses	4,500,000
		Long-term debt	5,310,000	EBIT	2,700,000
		Total liabilities	8,190,000	Interest expense	810,000
		Common stock	1,102,500	EBT	1,890,000
Net fixed assets	7,200,000	Retained earnings	3,307,500	Taxes	472,500
		Total equity	4,410,000	Net income	$1,417,500
Total assets	$12,600,000	Total debt and equity	$12,600,000

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. I’m going to check the box to the side of your calculated value if your calculation is correct and leave it unchecked if your calculation is incorrect.

Pavo Media Systems Inc. DuPont Analysis

Ratios	Value	Correct/Incorrect	Ratios	Value	Correct/Incorrect
Profitability ratios			Asset management ratio
Gross profit margin (%)	40.00		Total assets turnover	1.43
Operating profit margin (%)	10.50
Net profit margin (%)	11.25		Financial ratios
Return on equity (%)	24.77		Equity multiplier	1.54

ASHLEY: 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:

Do not round intermediate calculations and round your final answers up to two decimals.

Pavo Media Systems Inc. DuPont Analysis

Ratios	Calculation				Value
Profitability ratios	Numerator		Denominator
Gross profit margin (%)		/		=
Operating profit margin (%)		/		=
Net profit margin (%)		/		=
Return on equity (%)		/		=
Asset management ratio
Total assets turnover		/		=
Financial ratios
Equity multiplier		/		=

ASHLEY: I see what I did wrong in my computations. Thanks for reviewing these calculations with me. You saved me from a lot of embarrassment! Mikel 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 Pavo’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.

Increase the efficiency of its assets so that it generates more sales with each dollar of asset investment and increases the company’s total assets turnover.

Reduce the company’s operating expenses, its cost of goods sold, and/or the interest rate on its borrowed funds because this will increase the company’s net profit margin.

Decrease the company’s use of debt capital because it will decrease the equity multiplier.

Decrease the amount of debt financing used by the company, which will decrease the total assets turnover ratio.

Answer 1

G19 - x fc =B11/D10 Н. 1 2 Cash 3 Accounts receivable Inventory 5 Current assets B C Balance Sheet 9,00,000 Accounts payable 18,00,000 Accruals 27,00,000 Notes payable 54,00,000 Current liabilities Long-term debt Total liabilities Common stock 72,00,000 Retained earnings Total equity 1,26,00,000 Total debt and equity 10,80,000 3,60,000 14,40,000 28,80,000 53,10,000 81,90,000 11,02,500 33,07,500 44,10,000 1,26,00,000 F Income Statement Sales 1,80,00,000 Cost of good 1,08,00,000 Gross profit 72,00,000 Operating ex 45,00,000 EBIT 27,00,000 Interest expe 8,10,000 18,90,000 Taxes 4,72,500 Net income 14,17,500 EBT 9 Net fixed assets 10 11 Total assets 12 13 Asset management ratio Total assets turnover Values 1.43 Correct/Incorrect 1.43 Correct 14 15 Profitability ratios 16 Gross profit margin (%) | 17 Operating profit margin (%) 18 Net profit margin (%) 19 Return on equity (%) Values 40 10.5 11.25 24.77 Correct/Incorrect 40% Correct 15% Incorrect 7.88% Incorrect 32.14% Incorrect Financial ratios Equity Multiplier 1.54 2 .86|Incorrect

G19 - X V fx =B11/D10 A 2 Cash 3 Accounts receivable 4. Inventory Current assets 5 B C Balance Sheet 900000 Accounts payable 1080000 1800000 Accruals 360000 2700000 Notes payable 1440000 5400000 Current liabilities 2880000 Long-term debt 5310000 Total liabilities 8190000 Common stock 1102500 7200000 Retained earnings 3307500 Total equity 4410000 12600000 Total debt and equity 12600000 Income Statement Sales 18000000 Cost of goods sold 10800000 Gross profit 7200000 Operating expenses 4500000 EBIT 2700000 Interest expense 810000 EBT 1890000 Taxes 472500 Net income 1417500 9 Net fixed assets 10 11 Total assets 12 13 Values =G2/B11 Correct/Incorrect Correct 1.43 14 15 Profitability ratios 16 Gross profit margin (%) 40 17 Operating profit margin (%) 10.5 18 Net profit margin (%) 11.25 19 Return on equity (%) 24.77 Values =G4/G2 =G6/G2 =G10/G2 =G10/D10 Correct/Incorrect Asset management ratio Correct Total assets turnover Incorrect Incorrect Financial ratios Incorrect Equity Multiplier 1.54 =B11/D10 Incorrect

As per Dupont Formula,

ROE = (Net Income Sales)*(Sales/Total Assets)*(Total Assets/Total Equity

Therefore, ROE = Net Profit Margin * Total Assets Turnover * Equity Multiplier

Option 1 & 2 are correct strategies to increase ROE. As can be seen from the break down of the ROE formula, increasing Net Income & total Asset turnover increases the ROE.

To increase the ROE, equity multiplier needs to be increased and not decreased, thus Options 3&4 are incorrect.