Learning objective

Identify what a DuPont analysis is.

Introduction

The purpose of this section is to discuss how the DuPont system enables one to examine a firm’s financial statements to determine what, if anything, is causing its return on investment or return on equity to fall short of expectations. This is accomplished by breaking these returns into three component parts: profit margin, asset turnover, and return on assets. Only when that area of weakness is identified can management take appropriate steps towards improvement.

DuPont system

The DuPont System allows us to examine a company’s financial statements and see where its profitability problems (if any) come from. The return on equity is broken down into the return on assets [net income/total assets] and into the equity multiples [total assets/total equity]. The product of the equity multiples and the return on assets is the return on equity.

Knowledge check

The DuPont system is a way of breaking down the return on equity into its component parts. One can find the return on equity is by multiplying the Return on Assets (ROA)times
1. The equity multiplier.
2. Debt to asset ratio.
3. Asset turnover.
4. Three.

This part of the breakdown shows that debt usage, as measured by the equity multiplier, can “lever up” the ROE. The more debt a company has, the larger its equity multiplier will be. The equity multiplier is perfectly redundant with the debt to asset ratio. That is, they measure the same thing but use a different scale of measurement. The equity multiplier is “1” for an equity only firm. As leverage increases, the equity multiplier decreases. For example, a company with a debt to asset ratio of 50 percent would have an equity multiplier of 2.

If a firm’s ROA is 10 percent, an increase in debt usage that causes the equity multiplier to rise from 2 to 3 will cause the ROE to rise from 20 percent to 30 percent. The reverse is also true. When a company is losing money, the equity multiplier “levers down” the ROE.

Knowledge check

If a company has an ROA of 15 percent and an equity multiplier of two times, its ROE would be
1. 7.5 percent.
2. 15 percent.
3. 30 percent.
4. We cannot solve this problem with the limited information provided.
If the company in the previous question increased its debt usage, its equity multiplier would increase. Suppose its equity multiplier increased to three times. What would happen to the ROE?
1. Decrease down to 5 percent
2. Increase to 45 percent.
3. Increase to 22.5 percent.
4. Increase to 18 percent.

DuPont system

The DuPont system allows us to further dissect the ratios. We can split the numerator and denominator of the ROA and place sales (revenue) in it.

We now can see that the ROA is the product of the profit margin [net income/sales] and the asset turnover [sales/total assets]. Today, some people refer to the asset turnover as the asset utilization ratio. It is the same ratio with a different name.

The profit margin shows the number of pennies of profit from each dollar of revenue. When sales are stable or increasing, the profit margin determines the company’s ability to control costs. So a declining profit margin generally signals a cost control problem. Of course, one could conceivably increase a profit margin by increasing prices. However, price increases may be unrealistic in a competitive environment.

The asset turnover ratio shows how well the company is using its asset base to produce sales. A low asset turnover implies insufficient sales or excessive assets, while a large turnover suggests that assets are being sufficiently used to produce sales.

From this breakdown we can see that a low ROA (or ROE) can be caused by inadequate cost control or inadequate sales.

Knowledge check

The second step in the DuPont analysis is to divide the ROA into the profit margin and asset turnover ratios. Which of these two ratios measures cost control?
1. Profit margin.
2. Asset turnover.
3. Neither ratio.
4. Both ratios.
When a company has a small asset turnover, we argue that it needs to
1. Increase its leverage.
2. Cut costs.
3. Improve its ability to use its assets to produce sales.
4. Decrease sales.

Illustrative problem

Suppose Company A and Company B are in the same industry and both of them have ROAs of 6 percent. Company A has a profit margin of 4 percent and an asset turnover of 1.5 times. Company B has a profit margin of two percent and an asset turnover of three times. The industry average profit margin is 3 percent, the asset turnover is 2.5 times, and the ROA for the industry is 7.5 percent. Because both companies have below average ROAs, what actions would you recommend for these two companies?

Total DuPont system

The following example highlights the use of the DuPont system.

	Companies
	A	B	C	Industry
Profit margin	4.5%	6.0%	3.0%	5.0%
Asset turnover	1.8	1.5	3.0	2.0
Return on assets	8.0%	9.0%	9.0%	10.0%

What does this tell us about the profitability of the three companies? Company A is below average in both cost control and ability to generate sales. Clearly, company B is controlling its costs better than the others. However, company B has a low asset turnover. Its focus should be on producing sales. Company C has a large asset turnover but a low profit margin. Its focus should be on cost control.

	A	B	C	Industry
Return on assets	8%	9%	9%	10%
Equity multiplier	4	2	1.33	2
Return on equity	32%	18%	12%	20%

What has happened to the relative rankings? Company A has moved to the top because of its use of debt. Company C is run very conservatively, so it is penalized. Which company is best? From the use of debt point of view, there is no one answer; it is a risk/return trade-off. From the point of view of how well the company is run, company C is the best run company. What would happen to company C’s ROE if C used an average amount of debt? It would rise to 18 percent.

Group exercise – Part A

	Profit Margin	Asset Turnover	ROA
1st Company	2%	6x	12%
2nd Company	6%	2x	12%
Industry Average	4%	4x	16%

Question: Both companies have the same return on assets, both are below the industry average. What actions would you recommend for these two companies?

Group exercise – Part B

	ROA	Equity Multiplier	ROE
3rd Company	12%	1.5x	18%
4th Company	10%	2.0x	20%
5th Company	8%	3.0	24%

Question: Which of these three companies is the most profitable?

Knowledge check

Suppose that a company has a profit margin of 5 percent, an asset turnover of 3, and an equity multiplier of 2. Its ROE would be 30 percent. Also suppose that the average company in the industry had a profit margin of 6 percent, an asset turnover of 3 times, and an equity multiplier of 1.5. Therefore, the industry average ROE is 27 percent. We can conclude that
1. The company is definitely more profitable than the average company in the industry.
2. The company’s return to shareholders is greater than the average company in the industry.
3. The company’s rate of return based on the size of its assets is below average.
4. The company’s return to shareholders is greater than the average company in the industry and the company’s rate of return based on the size of its assets is below average.
Compute the ROE for a company with a debt to asset ratio of 50 percent, a profit margin of 5 percent and an asset turnover of 2 times. It is
1. 20 percent.
2. 10 percent.
3. 5 percent.
4. Some other number.

EBITDA analysis

EBITDA refers to earnings before deduction of interest expense income taxes, depreciation and amortization (depletion). This number is often used in ratio analyses prepared by stock analysts. By using this number, the analyst attempts to reduce the effect of outside influences (such as interest expense), the impact of timing (depreciation), and the impact of authorities on profit.

For these ratios we also use operating assets. Operating assets are total assets less investments and other assets, and they, therefore, include most current assets and property plant and equipment.

This ratio provides a measure of profitability that focuses on operations without the outside influences discussed above.

As in the DuPont system, we can identify the two components that make up the operating ROA. They are as follows:

Operating ROA = Operating Margin Operating Asset Turnover

Operating margin measures the efficiency of operations in producing operating profits. That is, it measures the number of pennies of EBITDA per dollar of sales.

Operating asset turnover measures management efficiency in utilizing operating assets to generate revenues.

Earnings quality

The quality of a company’s earnings depend upon its perceived ability to continue profits at this level or better and the relationship of earnings to cash flow. The key word here is perception because the measurement of earnings quality is judgmental and the analyst must rely on several factors to form an opinion.

Knowledge check

Earnings quality is measured by two things, the relationship of earnings to cash flow and
1. The firm’s ROE.
2. The perceived ability of the firm to continue earning as the current level or better.
3. Both of the previous answers.
4. The current ratio.

Continuation of earnings

Continuation of earnings can be measured by examining five factors. These include

strength of the balance sheet,
presence of one-time transactions,
age of the assets,
adequacy of research and development, and
age and incentive of key managers.

If a company has a weak balance sheet, it may not be able to maintain earnings. Recall that a weak balance sheet would mean a company has excessive debt or inadequate liquidity or both. In either case the company’s earnings will suffer more when there is an inevitable downturn in the business cycle. Excessive debt will lever-down the earnings when economic times become tough.

Knowledge check

A strong balance sheet implies _______ earnings quality.
1. Good.
2. Poor.
3. No relationship with.
4. No.

Second, a company that has increased its earnings through one-time transactions will not be able to maintain its’ earnings. For example, suppose a company has a gain because it sold fixed assets at a profit, or because it sold its investment in financial securities. These transactions cannot be repeated year after year. The presence of one-time transactions reduces the quality of earnings. You might consider removing the effect of one-time transactions from profit and profitability ratios when you examine the company.

Third, you should examine the age of the company’s assets. If a company does not replace its assets, sometime in the future it will potentially be faced with considerable investment. Thus, with aging assets it will not be able to maintain its profits over the long run. To estimate the age of assets you can divide the accumulated depreciation by the year’s depreciation expense.

Fourth, you should examine a company’s research and development expenditures across time and relative to its industry. If a company stops research and development, even temporarily, future profits will suffer. This is especially true in industries with rapid technological changes, such as the computer or electronics industries. However, it may be relatively less important in other industries. To examine this concept you should compute the research and development expenses relative to sales across time and if available to an industry average.

Knowledge check

Suppose that a company’s ratio of accumulated depreciation to depreciation expense increased from 3.5 to 5.9 over the past four years. This would be a sign of _________ earnings quality.
1. Good.
2. Poor.
3. Neither good nor poor.
4. This ratio is unrelated to earnings quality.

Finally, you should examine the age of the key managers and the incentive systems within the company, especially when the managers have a defined benefit retirement system. As managers move closer to retirement age, and if their pay is closely tied to corporate earnings, there are incentives created to inflate current corporate earnings, their pay, and therefore their retirement benefits. Please note that we are not arguing that older managers are less effective or dishonest. However, as analysts, we need to be aware that the possibility exists for these misaligned incentives.

Knowledge check

If all senior managers are nearing retirement age, we argue that this is a sign of _____________ earnings quality.
1. Poor.
2. Good.
3. Neither good nor poor.
4. Manager age is unrelated to earnings quality.

Relationship to cash flow

There are four things for you to examine when determining the relationship of earnings to cash flow. The first is fraud. Fraud can take many forms, and unless a company has discovered the fraud, the effect of it on earnings quality cannot be determined. Second, you should look at the company’s accounting policies in relationship with the industry, and determine the effect of any recent accounting changes. There is considerable latitude given companies in the selection of accounting principles. The selection of one type of procedure vs. others can affect earnings. It may be difficult to determine the exact effect of one procedure vs. the others, but you can look for several of the following:

Look at the accounting policies of the company in relationship to those of two or three other companies in the same industry. Are they the same, different?
Has the company recently changed (reduced) the amount of expense that they allocate for bad debts, warranties, or other reserve and contingency accounts? If so, this may overstate earnings.
Has the company changed auditors recently? If so, it may be the result of a disagreement over accounting principles. However, some companies change auditors for more legitimate reasons, so a change does not always indicate an earnings quality problem.
Do the footnotes indicate a recent change in accounting practices? If so, does the company show the effect on earnings?
If deferred taxes are growing rapidly, more rapidly than in previous years, this indicates a big difference between financial reporting income and tax income. This may mean that the company has used aggressive accounting practices for financial reporting but conservative practices for taxes.
Does the auditor’s report contain any qualifications? If so, the auditor may have a disagreement with management over the presentation of the financial results. You would need to estimate the effect of this disagreement on earnings.

Third, you need to look into the possibility that a company accelerated sales at year end. If a company has run a promotion at year-end with excessive discounts or with overly liberal credit terms, the sales for the current year may be overstated. This would tend to boost the current year’s earnings at the expense of the future, and would make the earnings less related to cash flow. One thing to watch for would be dramatic increases in accounts receivable. While this often occurs because of other problems or policies, it may occur when a company has attempted to accelerate its sales.

Finally, you should compare the various earnings ratios with those that use cash flow instead of earnings. The cash return on equity is a good example. You compute this ratio by dividing net cash from operations by stockholders’ equity.

The interpretation of this ratio is the same as for the ROE, but you are examining cash flow instead of income. Similarly, you can compute a cash return on assets or a cash margin. Thus, a complete DuPont analysis is possible with cash instead of income.

Why would you want to examine cash flow in addition to income? It is cash flow that keeps a company afloat. A company pays its creditors and employees in cash. Shareholders that expect dividends are generally paid in cash. Cash is the basis for most transactions and is necessary for a business to survive. It is possible for a company to have positive income, but negative cash flow from operations. So, monitoring cash along with income is appropriate.

Knowledge check

The perceived ability to continue earning at the current rate would be questioned if
1. A material portion of the company’s earnings came from an extraordinary gain.
2. The ratio of R&D to sales increased.
3. The age of a company’s assets decreased.
4. There is a wide range of manager ages.
When a company has used the same auditor for a long period of time, this implies what type of earnings quality?
1. Poor.
2. Good.
3. It can imply good or poor earnings quality, but may have no effect on earnings quality.
4. Good earnings quality as long as the auditor has a good reputation.

Review questions

What is the DuPont system used for?
How is the profit margin a measure of cost control?
How does debt increase an ROE?