DuPont System Financial Statement Analysis PDF

19/09/2024 DuPont System Financial Statement Analysis José Antonio LANAU 1 The DuPont System Method to breakdown ROE into: – ROA and Equity Multiplier ROA is further broken down as: – Prof...

19/09/2024 DuPont System Financial Statement Analysis José Antonio LANAU 1 The DuPont System Method to breakdown ROE into: – ROA and Equity Multiplier ROA is further broken down as: – Profit Margin and Asset Turnover Helps to identify sources of strength and weakness in current performance Helps to focus attention on value drivers 2 Basic formula ROE = (Profit margin)*(Asset turnover)*(Equity multiplier) = (Net profit/Sales)*(Sales/Assets)*(Assets/Equity) Operating efficiency (measured by profit margin) Asset use efficiency (measured by asset turnover) Financial leverage (measured by equity multiplier) 3  19/09/2024 ROE analysis The Du Pont identity breaks down Return on Equity (that is, the return to equity that investors have contributed to the firm) into three distinct elements. This analysis enables the analyst to understand the source of superior (or inferior) return by comparison with companies in similar industries (or between industries). The Du Pont identity, however, is less useful for some industries, such as investment banking, that do not use certain concepts or for which the concepts are less meaningful. Variations may be used in certain industries, as long as they also respect the underlying structure of the Du Pont identity. Du Pont analysis relies upon the accounting identity, that is, a statement (formula) that is by definition true. 4 Examples High turnover industries High Margin Industries High Leverage Industries 5 High Turnover Industries Certain types of retail establishments, particularly grocery stores, may have very low profit margins on sales, and relatively moderate leverage. In contrast, though, groceries may have very high turnover, selling a significant multiple of their assets per year. The ROE of such firms may be particularly dependent on performance of this metric, and hence asset turnover may be studied extremely carefully for signs of under-, or, over- performance. For example, same store sales of many retailers is considered important as an indication that the firm is deriving greater profits from existing stores (rather than showing improved performance by continually opening new stores). 6  19/09/2024 High Margin Industries Other industries, such as fashion, may derive a substantial portion of their competitive advantage from selling at a higher margin, rather than higher sales. For high-end fashion brands, increasing sales without sacrificing margin may be critical. The Du Pont identity allows analysts to determine which of the elements is dominant in any change of ROE. 7 High Leverage Industries Some sectors, such as the financial sector, rely on high leverage to generate acceptable ROE. In contrast, however, many other industries would see high levels of leverage as unacceptably risky. Du Pont analysis enables the third party (relying primarily on the financial statements) to compare leverage with other financial elements that determine ROE among similar companies. 8 The DuPont System ROE ROA Equity Multiplier Profit Margin Total Asset Turnover 9  19/09/2024 The DuPont System ROE ROA Equity Multiplier Profit Margin Total Asset Turnover ROE  ROA  Equity Multiplier Net Income Total Assets   Total Assets Common Equity 10 The DuPont System ROE ROA Equity Multiplier Profit Margin Total Asset Turnover ROA  Profit Margin  Total Asset Turnover Net Income Sales   Sales Total Assets 11 The DuPont System ROE ROA Equity Multiplier Profit Margin Total Asset Turnover ROE  Profit Margin  Total Asset Turnover  Equity Multiplier Net Income Sales Total Assets    Sales Total Assets Common Equity 12  19/09/2024 An Example: Dell Abbreviated Balance Sheet Assets: – Current Assets: $7,681.00 – Non-Current Assets: $3,790.00 – Total Assets: $11,471.00 Liabilities: – Current Liabilities: $5,192.00 – LT Debt & Other LT Liab.: $971.00 – Equity: $5,308.00 – Total Liab. and Equity: $11,471.00 13 13 An Example: Dell Abbreviated Income Statement Sales $25,265.00 Costs of Goods Sold -$19,891.00 Gross Profit $5,374.00 Cash operating expense -$2,761.00 EBITDA 2,613.00 Depreciation & Amortization -$156.00 Other Income (Net) -$6.00 EBIT $2,451.00 Interest -$0.00 EBT $2,451.00 Income Taxes -$785.00 Net Income (EAT) $1,666.00 14 14 The DuPont System: Dell Net Income Sales Total Assets ROE    Sales Total Assets Common Equity  Profit Margin  Total Asset Turnover  Equity Multiplier  ROA  Equity Multiplier $1,666.00 $25,265.00 $11,471.00 ROE    $25,265.00 $11,471.00 $5,308.00  0.0659  2.2025  2.1611  0.1452  2.1611  31.39% 15 15  19/09/2024 Tax Interest Asset Profit Leverage Burden Burden Turnover Margin Ratio 16 The company's tax burden is (Net profit ÷ Pretax profit). This is the proportion of the company's profits retained after paying income taxes. The company's interest burden is (Pretax profit ÷ EBIT). This will be 1.00 for a firm with no debt or financial leverage. The company's operating profit margin or return on sales (ROS) is (EBIT ÷ Sales). This is the operating profit per dollar of sales. The company's asset turnover (ATO) is (Sales ÷ Assets). The company's leverage ratio is (Assets ÷ Equity), which is equal to the firm's debt to equity ratio + 1. This is a measure of financial leverage. The company's return on assets (ROA) is (Return on sales x Asset turnover). The company's compound leverage factor is (Interest burden x Leverage). 17