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Finman WEEK 4
Business Finance (YMATHBUSFIN)
Holy Angel University
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Understanding the DuPont Analysis The DuPont analysis is a formula used to track a company's financial performance. It was developed in 1914 by F. Donaldson Brown, who worked for the DuPont Corporation. His formula incorporates earnings, investment, and working capital together into a single figure that he called return on investment (ROI). It became a standard measure for all DuPont departments and was adopted by other companies. A DuPont analysis is used to evaluate the component parts of a company's ROE. This allows an investor to determine what financial activities contribute the most to the changes in ROE. An investor can use tools like this to compare the operational efficiency of two similar firms. Managers can use DuPont analysis to identify strengths or weaknesses that should be addressed. There are three major financial metrics that drive ROE: - operating efficiency, which is represented by net profit margin or net income divided by total sales or revenue - asset use efficiency, which is measured by the asset turnover ratio - financial leverage—a metric that is measured by the equity multiplier, which is equal to average assets divided by average equity Formula and Calculation of DuPont Analysis The Dupont analysis is an expanded return on equity formula, calculated by multiplying the net profit margin by the asset turnover by the equity multiplier. DuPont Analysis = Net Profit Margin×AT×EM NET PROFIT MARGIN=NET INCOME / REVENUE ASSET TURNOVER = SALES/ Average total sales EQUITY MULTIPLIER = AVERAGE TOTAL ASSETS / AVERAGE SHAREHOLDERS EQUITY The DuPont analysis is also known as the DuPont identity or DuPont model. DuPont Analysis Components DuPont analysis breaks ROE into its constituent components to determine which of these factors are most responsible for changes in ROE. Net Profit Margin The net profit margin is the ratio of bottom line profits compared to total revenue or total sales. This is one of the most basic measures of profitability. One way to think about the net margin is to imagine a store that sells a single product for $1. After the costs associated with buying inventory, maintaining a location, paying employees, taxes, interest, and other expenses, the store owner keeps $0 in profit from each unit sold. That means the owner's profit margin is 15%, which can be calculated as follows:
Profit Margin=Net Income / Revenue % The profit margin can be improved if costs for the owner were reduced or if prices were raised, which can have a large impact on ROE. This is one of the reasons that a company's stock will experience high levels of volatility when management makes a change to its guidance for future margins, costs, and prices. Asset Turnover Ratio The asset turnover ratio measures how efficiently a company uses its assets to generate revenue. Imagine a company had $100 of assets, and it made $1,000 of total revenue last year. The assets generated 10 times their value in total revenue, which is the same as the asset turnover ratio and can be calculated as follows: Asset Turnover Ratio = Revenue / Average Assets=$1,000$100= A normal asset turnover ratio will vary from one industry group to another. For example, a discount retailer or grocery store will generate a lot of revenue from its assets with a small margin, which will make the asset turnover ratio very large. On the other hand, a utility company owns very expensive fixed assets relative to its revenue, which will result in an asset turnover ratio that is much lower than that of a retail firm. The ratio can be helpful when comparing two companies that are very similar. Because average assets include components like inventory, changes in this ratio can signal that sales are slowing down or speeding up earlier than they would show up in other financial measures. If a company's asset turnover rises, its ROE improves. Financial Leverage Financial leverage, or the equity multiplier, is an indirect analysis of a company's use of debt to finance its assets. Assume a company has $1,000 of assets and $250 of owner's equity. The balance sheet equation will tell you that the company also has $750 in debt (assets - liabilities = equity). If the company borrows more to purchase assets, the ratio will continue to rise. The accounts used to calculate financial leverage are both on the balance sheet, so analysts will divide average assets by average equity rather than the balance at the end of the period, as follows: Financial Leverage=Average Assets / Average Equity=$1,000 / $250= Most companies should use debt with equity to fund operations and growth. Not using any leverage could put the company at a disadvantage compared with its peers. However, using too much debt in order to increase the financial leverage ratio—and therefore increase ROE—can create disproportionate risks. A point to note, though, is that some companies use balance sheet averages when one of the components is an income statement metric. In the case noted above, no averaging is necessary as the equation takes balance sheet/balance sheet figures into account.
Finman WEEK 4
Course: Business Finance (YMATHBUSFIN)
University: Holy Angel University
