The DuPont ratio can be used as a compass in the process of assessing financial performance of the company by directing the analyst toward significant areas of strength and weakness evident in the financial statements.
The DuPont ratio is calculated as follows:
The ratio provides measures in three of the four key areas of analysis, each representing a compass bearing, pointing the way to the next stage of the investigation.
The DuPont Ratio Decomposition
The DuPont ratio is a good place to begin a financial statement analysis because it measures the return on equity (ROE). A for-profit business exists to create wealth for its owner(s). ROE is, therefore, arguably the most important of the key ratios, since it indicates the rate at which owner wealth is increasing. The three components of the DuPont ratio, as represented in equation, cover the areas of profitability, operating efficiency and leverage.
o Profitability:
Net Profit Margin Profitability ratios measure the rate at which either sales or capital is converted into profits at different levels of the operation. As we have seen, the most common are gross, operating and net profitability, which describe performance at different activity levels. Of the three, net profitability is the most comprehensive since it uses the bottom line net income in its measure.
The net profitability for XYZ Technologies in 2010 is:
A proper analysis of this ratio would include at least three to five years of trend and cross sectional comparison data. The cross sectional comparison can be drawn from a variety of sources.
o Asset Utilization: Total Asset Turnover
Turnover or efficiency ratios are important because they indicate how well the assets of a firm are used to generate sales and/or cash. While profitability is important, it doesn’t always provide the complete picture of how well a company provides a product or service. A company can be very profitable, but not too efficient. Profitability is based upon accounting measures of sales revenue and costs. Such measures are generated using the matching principle of accounting, which records revenue when earned and expenses when incurred. Hence, the gross profit margin measures the difference between sales revenue and the cost of goods actually sold during the accounting period. The goods sold may be entirely different from the goods produced during that same period. Goods produced but not sold will show up as inventory assets at the end of the year. A firm with abnormally large inventory balances is not performing effectively, and the purpose of efficiency ratios is to reveal that fact.
The total asset turnover (TAT) ratio measures the degree to which a firm generates sales with its total asset base. It is important to use average assets in the denominator to eliminate bias in the ratio calculation. Financial ratio bias is commonly present when combining items from both the balance sheet and income statement. For example, TAT uses income statement sales in its numerator and balance sheet assets in the denominator. Income statement items are flow variables measured over a time interval, while balance sheet items are measured at a fixed point in time. In cases where the firm has been involved in major change, such as an expansion project, balance sheet measures taken at the end of the year may misrepresent the amount of assets available and/or in use over the course of the year. Taking a simple average for balance sheet items (i.e., ((beginning + ending)/2)) will control for at least some of this bias and provide a more accurate and meaningful ratio. The limiting assumption is that the change in the balance sheet occurred evenly over the course of the year, which may not always be the case.
o Leverage: The Leverage Multiplier
Leverage ratios measure the extent to which a company relies on debt financing in its capital structure. Debt is both beneficial and costly to a firm. The cost of debt is lower than the cost of equity, an effect which is enhanced by the tax deductibility of interest payments in contrast to taxable dividend payments and stock repurchases. If debt proceeds are invested in projects which return more than the cost of debt, owners keep the residual, and hence, the return on equity is “leveraged up.” The debt sword, however, cuts both ways. Adding debt creates a fixed payment required of the firm whether or not it is earning an operating profit, and therefore, payments may cut into the equity base. Further, the risk of the equity position is increased by the presence of debt holders having a superior claim to the assets of the firm. The leverage multiplier employed in the DuPont ratio is directly related to the proportion of debt in the firm’s capital structure. The measure, which divides average assets by average equity, can be restated in two ways, as follows:
o Combination and Analysis of the Results
Once the three components have been calculated, they can be combined to form the ROE, as follows:
=22.92 * 1.06 * 1 = 24.3.
While additional measures for prior years would provide the basis for a necessary trend analysis, this result is not meaningful until it is compared to an industry or best practices benchmark. The DuPont ratio/or the Indian IT Industry is:
20*1.01 * 1.1 = 22.2%
As can be seen, strengths in XYZ are immediately evident in the comparison of DuPont values for XYZ and Indian IT Industry. The company appears to be significant in profitability, while total asset turnover seems to be roughly in line with the industry. The overall industry leverage is slightly higher than XYZ’Ss zero debt balance sheet. The analyst can now focus on the company’s profitability. A quick analysis of profitability yields the following result:
Sound financial statement analysis is an integral part of the management process for any organization. The DuPont ratio, while not the end in itself, is an excellent way to get a quick snapshot view of the overall performance of a firm in three of the four critical areas of ratio analysis, profitability, operating efficiency and leverage. By identifying strengths and/or weaknesses in any of the three areas, the DuPont analysis enables the analyst to quickly focus his or her detailed study on a particular spot, making the subsequent inquiry both easier and more meaningful. Some caveats, however, are to be noted.
The DuPont ratio consists of very general measures, drawing from the broadest values on the balance sheets and income statements (e.g., total assets is the most broad of asset measures). A DuPont study is not a replacement for detailed, comprehensive analysis. Further, there may be problems that the DuPont decomposition does not readily identify. For example, an average outcome for net profitability may mask the existence of a low gross margin combined with an abnormally high operating margin. Without looking at the two detailed measures, understanding of the true performance of the firm would be lost.
The DuPont ratio can also be broken into more components called ‘The Extended DuPont’, depending upon the needs of the analyst In any case, the DuPont can add value, even “on the fly,” to understand and solving a broad variety of business problems.
o Extended DuPont Formula
