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An analysis of company performance using DuPont analysis

Walking down the hall of your office building with a sheaf of papers in his hand, your friend and colleague, Landon, stepped into your office and asked the following.
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LANDON: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?

LANDON: 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. Amelia, 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 Amelia 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.

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Balance Sheet Data

Income Statement Data

Cash $700,000 Accounts payable $840,000 Sales $14,000,000
Accounts receivable 1,400,000 Accruals 280,000 Cost of goods sold 7,000,000
Inventory 2,100,000 Notes payable 1,120,000 Gross profit $7,000,000
Current assets $4,200,000 Current liabilities $2,240,000 Operating expenses 3,500,000
Long-term debt 3,640,000 EBIT $3,500,000
Total liabilities $5,880,000 Interest expense 571,200
Common stock 980,000 EBT $2,928,800
Net fixed assets 5,600,000 Retained earnings 2,940,000 Taxes 1,025,080
Total equity $3,920,000 Net income $1,903,720
Total assets $9,800,000 Total debt and equity $9,800,000

Question #1 If I remember correctly, the DuPont equation breaks down our ROE into three component ratios: the _________ ,
A. Net Profit Margin
B. Gross Profit Margin

Question #2 the total asset turnover ratio, and the ___________ .
A. Equity Ratio
B. Equity Multiplier

Question #3 And, according to my understanding of the DuPont equation and its calculation of ROE, the three ratios provide insights into the company’s _________ ,
A. Use of debt versus equity financing
B. Management of its sales and share prices
Question #4 effectiveness in using the company’s assets, and _________ .
A. Management of its liquidity and its tax records
B. Control over its expenses

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.

Hydra Cosmetics Inc. DuPont Analysis

Ratios Value Question #3 Correct/Incorrect Ratios Value Question #4 Correct/Incorrect
Profitability ratios Asset management ratio A. Correct B. Incorrect
Gross profit margin (%) 50.00 A. Correct B. Incorrect Total asset turnover 1.43 A. Correct B. Incorrect
Operating profit margin (%) 20.92 A. Correct B. Incorrect
Net profit margin (%) 19.43 A. Correct B. Incorrect Financial ratios
Return on equity (%) 46.35 A. Correct B. Incorrect Equity multiplier 1.67 A. Correct B. Incorrect

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LANDON: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:
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Note: Do not round intermediate calculations. Round final answers to the nearest whole number.

Hydra Cosmetics Inc. DuPont Analysis

Question #5 Calculation Question #6 Value
Profitability ratios Numerator Denominator
Gross profit margin (%)

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Operating profit margin (%)

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Net profit margin (%)

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Return on equity (%)

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Asset management ratio
Total asset turnover

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Financing ratios
Equity multiplier

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LANDON:I see what I did wrong in my computations. Thanks for reviewing these calculations with me. You saved me from a lot of embarrassment! Amelia would have been very disappointed in me if I had showed her my original work.

So, now let’s switch topics and identify general strategies that could be used to positively affect Hydra’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?
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Question #7 Check all that apply.

A. Increase the efficiency of its assets so that it generates more sales with each dollar of asset investment and increases the company’s total asset turnover.
B. Use more equity financing in its capital structure, which will increase the equity multiplier.
C. Decrease the company’s use of debt capital because it will decrease the equity multiplier.
D. 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.
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LANDON: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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