Providing Students with an Overview of Financial Statements Using the Dupont Analysis Approach Dr. Gene Milbourn, University of Baltimore, Maryland Dr. Tim Haight, California State University, Los Angeles, CA ABSTRACT
This paper uses the Dupont Analysis as a teaching aid to equip students with an understanding of how management decisions influence the bottom line. This simplified approach allows students to see the “big picture” and to logically follow how management decisions affect components that contribute to firm’s performance. As such it can be a valuable tool in building a student’s critical thinking competencies in evaluating the health, prospects and valuations of companies. INTRODUCTION
The volume of information contained in the balance sheet and income statement often overwhelms students in an introductory finance class. While basic accounting classes prepare students in the preparation of financial statements, finance classes typically focus on their interpretation to aid in decision-making. Unfortunately, entering students are often lost in the detail and are unable to see the forest for the trees. The ultimate goal is for students to understand the interrelationships between financial statements and how management decisions affect firm’s performance. To be sure, our future managers must fully understand the financial consequences of all the decisions and how these decisions affect the bottom line. Fortunately, there is a very powerful financial tool to assist students in understanding the ramifications of decisions on profitability. The Dupont Analysis is a measurement instrument that can provide students with several insights into key factors that contribute to bottom line performance. This tool is used to evaluate a firm’s financial condition by comparing relationships within the income statement and balance sheet, or between the two statements. The Dupont Analysis provides information on the firm’s liquidity, profitability, efficiency, and leverage status, thus allowing students to see how well a firm is operating as a result of changes in one or more of these factors. It is a very powerful tool that allows one to trace the financial impact of decisions and to understand the interrelationship between the income statement, balance sheet and firm profitability RETURN ON ASSETS: THE OPERATING INCOME VIEW
Dupont analysis begins by using the firm’s return on assets (ROA). Return measures can either be on a before-tax or an after-tax basis. Here, we will illustrate return using ROA, an after tax measure which is defined as follows: ROA = Net Income After Taxes (NIAT) Assets (invested capital)
{equation 1}
ROA measures the firm’s profits as a percent of its assets. Note that ROA increases if any one of the three following factors changes while the other two remain the same: • • •
if costs decrease, income increases, so ROA increases; if revenue increases, income increases, so ROA increases; if assets decrease, ROA increases.
Students can quickly gain an understanding of how any of these changes affect return. To provide a context for classroom discussion, the instructor will evaluate a firm’s performance, ROA with either an industry average or the firm’s historic returns. If the firm has higher ROA than the industry, the firm is more profitable. Similarly, if the firm’s ROA is lower than the industry’s it is viewed as less profitable.
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DUPONT ANALYSIS: BREAKING ROA DOWN INTO TWO ELEMENTS
In Dupont analysis, the ROA is expanded and broken down into two components: ROA = NIAT/
Revenue
X
Revenue/Assets {equation #2}
Where: Revenue/Assets = Asset turnover (measure of resource efficiency) and NIAT/Revenue = Net Profit Margin (profits related to sales generated) Thus, Dupont analysis translates the basic ROA ratio into the following: ROA = Asset Turnover x Net Profit Margin {equation 2} These two sub-measures are useful in the following way: • •
Asset turnover measures the efficiency of the firm’s assets. The higher this ratio, the more efficient the assets. Operating profit margin is an indicator of the firm’s profitability as it relates to revenue.
These two measures, when combined, permit students to see the relative contributions of asset efficiency and profitability on the firm’s Return on Assets. The use of the Dupont System to investigate firm performance can employed on a time series basis or as part of a cross sectional analysis within a given industry or sector. Typically, a firm can isolate the causes of deteriorating ROA over time by separating the relative impact of its asset turnover and profit margin during the period under investigation. Once the source of the deteriorating ROA is isolated, firms can then focus on the area suggested by the Dupont System. Often changes in firm’s performance are a result of external factors that may be affecting the entire industry and/or sector within the industry. Here, cross sectional analysis can be employed to ascertain whether performance problems are isolated within the firm or are being experienced by competitors as well. ILLUSTRATION
The analysis below will investigate the relative firm performance of two firms within a hypothetical industry. The Dupont Analysis is illustrated using the income statements and balance sheet statements of firms A and B in Table 1 and Table 2. For this illustration we will assume that accounting treatment of such items, as depreciation and inventory valuation are consistent. Each firm is examined on the basis of ROA and compared to its industry norm in Table 3. The Dupont analysis is then used to examine the relative contributions of the efficiency and profitability components to each firm’s ROA to understand in greater depth the key factors affecting the firm’s performance.
Sales Cost of Goods Sold Gross profits
Table 1 Firms A and B: Income Statements A $550,000 305,000 $245,000
General & Administrative
B
$600,000 400,000 $200,000
110,000
95,000
Net Operating Income Interest expense Earnings before taxes Taxes (40%)
$135,000 7,500 $127,500 51,000
$105,000 10,000 $95,000 38,000
Net Income After Taxes (NIAT)
$ 76,500
$ 57,000
*Analysis assumes a 40% marginal tax rate
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COMPARISON OF FIRM A VS. FIRM B
Using Equation 1 (ROA = NIAT/Assets) and the information contained in Tables 1 and 2, the ROA for firms A and B is calculated as follows: Firm A: ROA = $ 76,500/$412,50 0 = 18.55% Firm B: ROA = $ 57,000/$396 ,000
= 14.39%
In terms of ROA, Firm A appears to be more profitable than Firm B with a ROA of 18.55% vs.14.39% for Firm B. Table 2 Firms A and B: Balance Sheets A
Assets Cash Accounts Receivable Inventory Current assets Plant and equipment (net) Total assets Liabilities and net worth Notes payable Accounts payable Accrued taxes Total current liabilities Long-term debt Capital stock Retained earnings Total liabilities and net worth
B
$ 10,000 85,000 67,500 $162,500 250,000 $412,500
$ 9,000 95,000 97,000 $201,000 195,000 $396,000
$ 2,000 58,000 7,500 $67,500
$ 3,100 63,000 8,900 $ 75,000
$ 100,000 $ 75,000 $170,000 $412,500
$ 125,000 $ 75,000 $121,000 $396,000
INDUSTRY COMPARISON USING THE DUPONT ANALYSIS
Now let us compare their performance with that of the industry that is reported in Table 3. As the table reveals, the industry average ROA is 16.8% In comparison to this performance measure, firm A’s return (18.55%) exceeded the industry norm while Firm B’s return (14.39%) fell short. What contributed to Firm A exceeding the industry average while Firm B performed below the industry benchmark? To answer this question we can turn to the Dupont Analysis. Using equation #2, ROA is subdivided into the asset turnover ratio and the net profit margin components. Table 3 Comparative Ratios Ratio* Firm A Firm B Net Profit Margin 13.91% 9.50% Revenue/ Assets 1.33x** 1.52x Return on Assets 18.55% 14.39% Current Assets/Current Liabilities 2.40 2.68 Average Collection Period 56days 57 days Cost of Goods Sold/Inventory 4.52x 4.12x * Firms A and B ratios are calculated from Tables 1 and 2, while the industry percentages are given. ** x indicates “times.”
Industry 12.0% 1.40.x 16.8% 2.50 60 days 4.00x
DUPONT ANALYSIS OF INDUSTRY
As reported in table 3, the industry’s ROA can be expanded as: ROA = Asset Turnover X Net Profit Margin 16.8% = 1.40 X 12%
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Dupont analysis reveals that the industry’s 16.8% return on assets is the result of an asset turnover of 1.40 and a net profit margin of 12%. DUPONT ANALYSIS OF FIRM A
Now that the relationship of asset efficiency and profitability has been identified on an industry level, the same technique can be used to examine the individual firm’s return components. The application of the Dupont technique to Firm A yields the following: NIAT Assets
=
Revenue Assets
$76,500 $412,500
=
$550,000 $412,500
18.55%
1.33
X
NIAT Revenue
X $ 76,500 $550,000 X
13.91%
These results can now be compared with the industry results. The analysis shows that firm A’s asset turnover (1.33) was below the industry average (1.40), while its net profit margin (13.9%) was above that of the industry (12%). Thus, Firm A’s superior performance was due to its higher profit margin than the industry average (i.e., 13.91% versus 12%) despite having a lower turnover. Firm A’s performance is impressive. It would be even more impressive if the firm could maintain its profit margin and increase its asset turnover to the industry’s level. We can use equation 2 to calculate Firm A’s ROA under this assumption. This yields the following result: ROA = 19.47%
Asset Turnover = 1.40
X X
Net Profit Margin 13.91%
At this point, it may be useful to have the students focus on the firm’s asset turnover ratio. Students will easily recognize that: • •
the firm can increase revenue while maintaining its present asset level or; the firm can reduce the amount of assets employed at its existing revenue level.
Regardless of which path is chosen the analysis shows the direction in which further examination should proceed. In this case, it appears that the firm’s investment in assets may be excessive. DUPONT ANALYSIS OF FIRM B
The same approach can be used for Firm B to reveal why its performance is low relative to the industry. Here, Dupont Analysis yields the following: NIAT Assets
=
Revenue Assets
$ 57,000 $396,000
=
$600,000 $396,000
14.39%
=
1.52
X
NIAT Revenue
X
$ 75,000 $600,000 X
9.50%
Dupont analysis shows that Firm B’s asset turnover (1.52) is well above the industry average (1.4), while its net profit margin (9.5%) is much lower than that of the industry (15%). Thus, Firm B’s sub par performance is due to its low net profit margin. Firm B’s Return on assets would have been even lower without its high resource utilization as measured by the asset turnover. Again returning to the Dupont Analysis, let’s assume that firm maintains its asset turnover and achieves the industry average’s net profit margin of 12.0%. The results are as follows: ROA = Asset Turnover X Net Profit Margin 18.24% = 1.52 X 12.0%
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Thus, Firm B would increase its ROA to 18.24 percent by increasing its profit margin to the industry’s average. Here again, the students should focus on the firm’s net profit margin. Should the firm increase prices, decrease costs, or both? Will the environment that the firm operates in allow for price increases? Can the firm become more efficient? Again, the framework for the discussion revolves around the Dupont Analysis. SUMMARY OF VARIANCES FOR FIRMS A AND B COMPARED TO THE INDUSTRY
For both firms, Dupont Analysis reveals that their variance in return was attributed to both the asset turnover and the profit margin components. In the case of Firm A, its asset turnover was below the industry average while its net profit margin was above the industry average. For Firm B, the opposite is true. They outperformed the industry in terms of asset turnover, but under performed on the basis of profit margins. However, in both instances the Dupont Analysis provided direction into the examination of performance causes. Using Dupont Analysis for Scenario Planning Dupont Analysis can also be useful as a planning tool. This approach allows students to explore how various scenarios affect ROA in terms of asset efficiency and profit margins. The impact of pricing decisions, increased expenses, and asset investment can be viewed based on its expected impact on asset returns. Thus, Dupont Analysis can be a useful planning aid as well as a diagnostic tool. To illustrate this point, consider Firm B’s current return on asset performance. The breakdown of its return o n assets is reproduced below:
ROA = Asset turnover 18.55% 1.33
X X
Net Profit margin 13.91%
Assume that management believes that it can increase its net profit margin from 13.91% to 14% by shipping directly from its foreign suppliers to its customers bypassing its current warehouse. Furthermore, let’s assume that if the existing supply-chain is altered, management also expects that its investment in inventory will decrease, increasing its asset turnover from 1.33 to 1.40. Finally, management expects revenue to remain the same. How will this affect the firm’s return on assets? Dupont analysis can be used to calculate the expected ROA. The calculations would be as follows: Projected ROA = 1.40 X 16.0% = 22.4% Under this scenario, ROA might increase from 18.55% to 22.4%. Thus, from a return on asset view, the new supply chain strategy should be explored. Additional analysis would be required before ultimately going forward, but its likely impact on ROA as shown above, can be easily ascertained. Many other financial issues can be addressed using Dupont Analysis. SUMMARY
The Dupont Analysis provides students with the framework to understand how decision-making affects the bottom line. Using this approach, students can gain a better appreciation of the interrelationship between the income statement and balance sheet, without getting bogged down in the details. Teaching financial analysis using this approach will assure the critical thinking skills that will better prepare students to be effective managers. REFERENCES Artz, William A., and Neihengben, N. (1997). Analysis of Finance Company Ratios. Journal of Lending and Credit Risk Management, 80, 3236. Brooks, R. M. and Johnson, M. F. (1997). CEO Presentations to Financial Analysts: Much Ado About Nothing? Financial Practice and Education 7, 19-28. Cunningham, D. F. and Rose, J. T (1995). Industry Norms in Financial Statement Analysis: A Comparison of RMA and D & B Benchmark Data, The Credit and Financial Management Review, 42-48. Ferguson, R. and Leistikow (1995). Search for the Best Financial Performance Measure. Financial Analysts Journal 54, 81-85. Firer, C. (1999). Driving Financial Performance Through the Dupont Identify. Financial Practice and Education 9, 34-45. Maness, T. S. and Zietlow (1997). Short-Term Financial Management, New York: Dryden Press, chapter 2. Park, K. and Ratti, R. (2000). Real Activity Inflation, Stock Returns, and Monetary Policy. Financial Review, 36, 59-78. Ramakrisnan, R. and Thomas, J. K. (1992). What Matters from the Past: Market Value, Book Value or Earnings? Journal of Accounting, Auditing & Finance, 7, 423-64.
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