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, Iâ€™ve got a meeting in an hour, but I donâ€™t want to start something new and then be interrupted by the meeting, so how can I help?
LANDON: Iâ€™ve been reviewing the companyâ€™s financial statements and looking for general ways to improve our performance, in general, and the companyâ€™s return on equity, or ROE, in particular. Amelia, my new team leader, suggested that I start by using a DuPont analysis, and Iâ€™d like to run my numbers and conclusions by you, to see if Iâ€™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 |
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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 companyâ€™s _________ ,
A. Use of debt versus equity financing
B. Management of its sales and share prices
Question #4 effectiveness in using the companyâ€™s assets, and _________ .
A. Management of its liquidity and its tax records
B. Control over its expenses
Now, letâ€™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 Iâ€™m going to select correct if your calculation is correct and incorrect if your calculation is incorrect.
Hydra Cosmetics Inc. DuPont Analysis |
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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 Iâ€™ve got a couple of incorrect values, so show me your calculations, and then we can talk strategies for improvement.
YOU:Iâ€™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 |
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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 letâ€™s switch topics and identify general strategies that could be used to positively affect Hydraâ€™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 companyâ€™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 companyâ€™s total asset turnover.
B. Use more equity financing in its capital structure, which will increase the equity multiplier.
C. Decrease the companyâ€™s use of debt capital because it will decrease the equity multiplier.
D. Reduce the companyâ€™s operating expenses, its cost of goods sold, and/or the interest rate on its borrowed funds because this will increase the companyâ€™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.