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DuPont Analysis Lecture Notes Jamal Munshi, 1994 All rights reserved
Ratio analysis basics
Income Statement • •
NOI = S*(1 - vc/s) - FC NIAT = (NOI - I)*(1-t)
Balance Sheet •
TA = D + E
Stmt of Cash Flows • •
CFO = NIAT + Dep CFC = [NOI + Dep]/[I + DS/(1-t)]
Ratios to assess operating decisions • • • •
PM = NOI/S TAU = S/TA ROI = NOI/TA Note that ROI = PM * TAU
Ratios to assess financial decisions • •
ROE = NIAT/E i = I/D
DuPont analysis equations • •
ROI = PM * TAU (for operating decisions) ROE = (1-t)*[ROI + (D/E)*(ROI-i)] (for financial decisions)
DuPont analysis of operating decisions: •
ROI is partitioned into two multiplicative components - that which can be ascribed to our ability to control costs and that affected by our ability to use assets to generate sales. It is an analytical tool and not a computational tool.
DuPont analysis of financial decisions : •
ROE is partitioned into two additive components - that whi ch can be ascribed to operations and an additional component due to financial leverage. It is an analytical tool and not a computational tool.
Definitions •
Income Stmt = matches costs to revenue in corresponding time periods.
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Balance sheet = Distribution of claims on assets.
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Cash flows = actual funds flowing to and from our checking account.
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PM [profit margin] = our ability to control costs = measured by the amount of operating income per dollar of sales.
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TAU [total asset utilization ratio] = our ability to use assets to generate sales = measured by the amount of sales generated per dollar of assets.
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ROI [return on assets] = bottom line of our operations that assesses whether it is a good business busi ness to be in = the amount of operating income generated per dollar of assets.
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i [little eye] = net cost of borrowed funds = measured as a percentage.
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ROE [return on equity] = the bottom line of the business enterprise that measures our ability to increase the wealth of the owners = measured as the amount of net income made available to our shareholders per dollar of their investment.
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DOL [degree of operating leverage] = the sensitivity of operating income to fluctuations in sales = the percentage change in NOI N OI caused by a one percent change in sales = a measure of risk inherent in our operations = caused by fixed costs in our cost structure.
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DFL[degree of financial leverage] = the sensitivity of net income to fluctuations in operating income = the percentage change in NIAT caused by a one percent change in NOI = additional risk induced by the use of borrowed funds = caused by fixed financial charges due to our capital structure.
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FFL [favorable financial leverage] = when ROI is greater than i debt can be used to leverage (increase) ROE beyond ROI*(1-t). Indifference point: ROI=i UFL [unfavorable financial leverage], ROI is less than i, increased use of debt (cp) decreases ROE