Using the DuPont System of Financial analysis

Post on: 16 Март, 2015 No Comment

Using the DuPont System of Financial analysis

DuPont Identity is also known as DuPont analysis, DuPont equation, DuPont Model or DuPont method. These names come from the DuPont Corporation that started using this formula in the 1920s.

DuPont identity is break down into three parts, there is profit margin, total asset turnover and financial leverage. The DuPont identity is less useful for some industries, such as investment banking, that do not use certain concepts or for which the concepts are less meaningful.

DuPont identity tells us that ROE(profit margin) is affected by three things:

Operating efficiency, which is measured by profit margin

Asset use efficiency, which is measured by total asset turnover

Financial leverage, which is measured by the equity multiplier

www.investopedia.com/terms/d/dupontidentity.asp

Section 2: Background Research

DuPont system of financial analysis are developed in 1919 by a finance executive at E.I. du Pont de Nemours and Co. of Wilmington, Del. In the days when the chemical giant cooked up financial formulae as well as hydrocarbons, the DuPont system still helps many companies visualize the critical building blocks in return on assets and return on investments.

The DuPont model is a way of visualizing the information so that everyone can see it, says accounting and MIS professor Stephen Jablonsky of Penn State University.

A typical DuPont chart resembles a chart drawn to mark the progress of competitors in a tennis or basketball tournament. Entries that ultimately make up before-tax return on investment include cost of goods sold, selling expenses, administrative expenses, inventories, accounts receivable and cash. At successive stages, they are added, subtracted, divided or multiplied until return on equity is reached.

Outside the cloistered confines of finance departments, where financial performance has not taken root among rank-and-file workers, the DuPont model can be very effective. “DuPont analysis is a good tool for getting people started in understanding how they can have an impact on results, said by Doug McCallen. Budgets and forecasts manager at construction and mining equipment maker Caterpillar Inc. in Peoria, Ill. where performance has turned around since the company launched reorganization in 1991. That was the year it formally heightened focus on specific accountabilities for different parts of the business. The DuPont model supports and reinforces those accountabilities, said by McCallen.

Nucor Corp. a $4 billion-a-year producer of steel and steel products, has been using return on assets employed to measure performance in its facilities for years, with salutary results.

Thoughts from time to time about trading DuPont convince most of the companies to used it.

www.bizlearning.net/news/news.cfm?newsitem=142

It was publish in the January 1998 issue of CFO magazine.

Section 3: Literature review

DuPont Identity

Usage of the DuPont Framework Application

Limitation of the DuPont Identity

Strength of the DuPont Identity

Usage of the DuPont Framework Application

These DuPont Framework Application Model can be used by the purchasing department and sales department. These model examine and demonstrate why a given Return On Asset (ROA) was earned. It also analyzes changes overtime. Beside that, these model teach people a basic understanding on how they can have an impact on company’s results. It shows the impact of professionalizing the purchasing function.

Strength of the DuPont Identity

Simplicity. A very good tool to teach people a basic understanding how they can have an impact on results.

Can be easily linked to compensation schemes.

Can be used to convince management that certain steps have to be taken to professionalize the purchasing or sales function. Sometimes it is better to look into your own organization first. Instead of looking for company takeovers in order to compensate lack of profitability by increasing turnover and trying to achieve synergy.

Limitation of the DuPont Identity

Based on accounting numbers, which are basically not reliable.

Does not include the Cost of Capital.

Garbage in, garbage out.

www.12manage.com/methods_dupont_model.html

Basic DuPont Identity Equations

( Part 1)

THE DUPONT MODEL — RETURN ON EQUITY

Analyzing the Three Components of Return on Equity :

As you learned in the investing lessons, return on equity (ROE) is one of the most important indicators of a firm’s profitability and potential growth. Companies that boast a high return on equity with little or no debt are able to grow without large capital expenditures, allowing the owners of the business to withdrawal cash and reinvest it elsewhere. Many investors fail to realize, however, that two companies can have the same return on equity, yet one can be a much better business.

For that reason, according to CFO Magazine, a finance executive at E.I. du Pont de Nemours and Co. of Wilmington, Delaware, created the DuPont system of financial analysis in 1919. That system is used around the world today and will serve as the basis of our examination of components that make up return on equity.

Calculation of Return on Equity

To calculate the return on equity using the DuPont model, simply multiply the three components (net profit margin, asset turnover, and equity multiplier.)

Return on Equity = (Net Profit Margin) (Asset Turnover) (Equity Multiplier).

Composition of Return on Equity using the DuPont Model:

There are three components in the calculation of return on equity using the traditional DuPont model; the net profit margin, asset turnover, and the equity multiplier. By examining each input individually, we can discover the sources of a company’s return on equity and compare it to its competitors.

Net Profit Margin

The net profit margin is simply the after-tax profit a company generated for each dollar of revenue. Net profit margins vary across industries, making it important to compare a potential investment against its competitors. Although the general rule-of-thumb is that a higher net profit margin is preferable, it is not uncommon for management to purposely lower the net profit margin in a bid to attract higher sales. This low-cost, high-volume approach has turned companies such as Wal-Mart and Nebraska Furniture Mart into veritable behemoths.

Two ways to calculate net profit margin:

Net Income ÷ Revenue

Net Income + Minority Interest + Tax-Adjusted Interest ÷ Revenue.

Whichever equation you choose, think of the net profit margin as a safety cushion; the lower the margin, the less room for error. A business with 1% margins has no room for flawed execution. Small miscalculations on management’s part could lead to tremendous losses with little or no warning.

Asset Turnover

The asset turnover ratio is a measure of how effectively a company converts its assets into sales. It is calculated as follows:

Asset Turnover = Revenue ÷ Assets

The asset turnover ratio tends to be inversely related to the net profit margin; i.e. the higher the net profit margin, the lower the asset turnover. The result is that the investor can compare companies using different models (low-profit, high-volume vs. high-profit, low-volume) and determine which one is the more attractive business.

Equity Multiplier

It is possible for a company with terrible sales and margins to take on excessive debt and artificially increase its return on equity. The equity multiplier, a measure of financial leverage, allows the investor to see what portion of the return on equity is the result of debt. The equity multiplier is calculated as follows:

Equity Multiplier = Assets ÷ Shareholders’ Equity.

Basic DuPont Identity Equations

( Part 2)

Return On Assets (ROA)

Return On Assets sometime called Return On Investment (ROI). It compares income as a percentage of total investment. It is a basic measure of profitability of a company; profit margin and efficiently of a company manages its assets; total assets turnover.

Return On Assets Formula:

Return On Assets (ROA) = Profit Margin X Total Assets Turnover

Return On Assets (ROA) = ( Net Income / Sales) X ( Sales / Total Assets)

These equation divides this into two factors; which are profit margin and asset turnover. It illustrates both profitability of operations (profit margin) and efficient use of assets (turnover).

Return On Equity (ROE)

Return on Equity (ROE) measures of profitability on assets actually provided by owners of a company.

Return On Equity Formula:

Return On Equity (ROE) = Return On Assets (ROA) X Equity Multiplier

Return on Equity (ROE) = Profit Margin X Total Assets Turnover X (Total Assets / Stockholder Equity)

DuPont System Analysis

These system analytical method that uses the balance sheet and income statement to break the Return On Assets(ROA) and Return On Equity (ROE) ratios to component pieces. It’s objective is to find out why a company’s profitability, as measured by ROA and ROE, is higher or lower than the industry average ROA or ROE or last year’s company ROA or ROE.

Equity Multiplier

Assets Management Ratios


Categories
Cash  
Tags
Here your chance to leave a comment!