Financial Statement Analysis. Dupont Analysis

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Cuthbert Freeman
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1 Financial Statement Analysis Dupont Analysis 1

2 The Four Financial Statements 1. Balance Sheet 2. Income Statement 3. Cash Flow Statement 4. Statement of Shareholders Equity

Assets - Liabilities Owners equity Statement of Shareholders Equity Investment and disinvestment by owners Net income and

3 The Articulation of the Financial Statements Beginning stocks Flows Ending stocks Cash Flow Statement Beginning Balance Sheet Cash Cash from operations Cash from investing Cash from financing Net change in cash Ending Balance Sheet Cash + Other Assets - Liabilities Owners equity Statement of Shareholders Equity Investment and disinvestment by owners Net income and other earnings Net change in owners equity + Other Assets - Liabilities Owners equity Income Statement Revenues Expenses Net income

4 Anatomy of Returns = Total Liabilities + Total Equity Total amount of stuff used in the business to make profits (inventory, machinery, etc.) How much of that stuff is financed by the bank, that is, debt capital. How much of that stuff is financed by your own money, that is, equity capital. So, when you make profits, those profits are a return to all the assets, some of which is a return to your money invested (equity capital) and some of which is a return to the bank s money (debt capital).

5 Anatomy of Returns Case 1 $1,000 of (all financed by my own money) generated $500 of total revenue, $400 of total expenses, and thus $100 of profits = $10 cents of income per dollar of asset ROROA = 10% Since it is all my money, then ROROE = 10%

6 Anatomy of Returns Case 2 $1,000 of (financed $700 by my own money and borrowed from a bank) generated $500 of total revenue, $400 of expenses before interest for $100 profit, and $76 profits after interest expenses. I leveraged someone else s money to increase the return to my money. My money (Equity Capital) Bank s money (Debt capital) $700 $1000 $ = = ROROE = 10.9% $10.9 cents of income per dollar of your money Before interest $.10 cents of income per dollar of all assets used. ROROA = 10% ROROA>i-rate The extra is payment to equity 10% 8% Thus 2% additional to Equity

7 So, How Is Money Made? Through Three Primary Levers By being efficient with your operations By getting the most out of your assets (minimizing investment) By leveraging your money that is, helping your own money do bigger and better things through borrowed use of someone else s money.

8 How can you improve? By analyzing each of the three levers that leads to Return on Equity ROROE: Profitability of operations Efficiency in use of assets Leverage

9 DuPont System Developed in 1919 by a finance executive at E.I. du Pont de Nemours and Co The DuPont system is a way of visualizing the information so that everyone can see it. (Stephen Jablonsky, Penn State University) DuPont analysis is a good tool for getting people started in understanding how they can have an impact on results (Doug McCallen, Caterpillar Inc.) Number one, it s simple (Sam Siegel, CFO)

10 DuPont System What is It? The system identifies profitability as being impacted by three different levers: 1. Earnings & efficiency in earnings 2. Ability of your assets to be turned into profits 3. Financial leverage Leverage Earnings Asset Turnover

11 DuPont System Income Stream Earnings/Efficiency Operating Profit Margin Asset Turnover Turnings/Asset Use Assets (less interest adj.) Equity Investment Stream Financial Structure Leverage

12 DuPont System Ratios Income Stream Investment Stream Earnings Operating Profit Margin Asset Turnover Turnings Financial Structure Leverage OPMR ATO Assets (less interest adj.) /Total Equity Derived from the Debt To Asset Ratio (D:A) ROROA ROROE Equity

13 DuPont System Earnings/Efficiency Operating Profit Margin Asset Turnover Turnings/Asset Use Assets (less interest adj.) Equity Financial Structure Leverage

14 Accounting Margins Gross margin Gross profit/sales Operating margin Operating profit/sales Net margin Net income/sales 14

15 Rate Of Assets ROROA = Net income + interest paid Operating Profit Margin Ratio Net income + interest pd Total Revenue X Asset Turnover Ratio Total Revenue

16 DuPont System Earnings/Efficiency Operating Profit Margin Asset Turnover Turnings/Asset Use Assets (less interest adj.) Equity Financial Structure Leverage

17 Rate Of Equity Net income ROROE = Total Equity Rate Of Assets Net income + interest pd. - i-rate Adj. interest pd. = Net income X Leverage Ratio Total Equity

18 Leverage is the mix of debt versus equity capital used in making profits. - Do we have too much debt? - Do we have enough debt? - Is our debt capital generating profits? - Can our debt capital be put to better use? Assets OK Equity Too Low Leverage Total Equity Too Low

19 Earnings Net income + interest Total Revenue OPMR Too Low Turnings Total Revenue ATO OK Assets Too Low Equity Too Low Leverage Total Equity OK

20 Earnings Turnings Net income + interest Total Revenue Total Revenue ATO Too Low OPMR Assets OK Too Low Equity Too Low Leverage Total Equity OK Also, selling off unproductive assets and paying off debt could change your leverage position in a positive way, and also improve your ROROE!

21 Financial Diagnostics via DuPont. Finding the Red Flags! Prices Production Quality Facilities Processes Operations Health Labor Repairs Timeliness Management Ability to Manage Assets Revenues too low for costs Costs too high for Revenues Obsolete or Inefficient Assets Unused or Under Utilized Assets OPM too Low ATO too Low Wrong Kind of Debt Not Enough Debt ROROA too Low Leverage ROROE too Low

22 Liquidity Ratios Current Ratio Current assets/current liabilities Quick Ratio (Acid Test Ratio) Current assets inventory/current liabilities Cash Flow Liquidity Ratio Cash + CFO/Current Liabilities 22

23 Solvency ratios Debt ratio Total liabilities/total assets Long term debt to total capitalization Long term debt/ Long term debt and stockholder s equity Debt to equity ratio Total Liabilities/Stockholder s Equity Times interest earned Operating profit/interest expense Cash interest coverage CFO + interest paid + taxes paid/interest paid 23

24 Efficiency Ratios 24

DRAFT. Hadley summed up well the reluctance in a 2012 E-Extension article:

DRAFT. Hadley summed up well the reluctance in a 2012 E-Extension article: DuPont System for Financial Analysis A Process for Discovering Where to Spend My Management Time Tomorrow Morning after Breakfast By Kevin Bernhardt October, 2015 1 I get very excited when I am faced with