DuPont System
For Financial
Analysis
By Kevin Bernhardt, UW-Platteville and UWExtension
March 10, 2010
http://cdp.wisc.edu/Management.htm
First,
This Thing
Called Debt
Anatomy of Returns
Total Assets = Total Liabilities + Total Equity
Total amount of stuff
used in the business to
make profits (supplies,
inputs breeding stock,
machinery, etc.)
How much of
that stuff is
financed by the
“bank”, that is,
debt capital.
How much of
that stuff is
financed by
your own
money, that is,
equity capital.
So, when you make profits, those profits are a return to
all the assets, some of which is a return to your money
invested (equity capital) and some of which is a return
to the bank’s money (debt capital).
Anatomy of Returns – Case 1
$1,000 of Total Assets (all financed by my own
money) generated $500 of total revenue, $400
of total expenses, and thus $100 of profits.
100
1000
=
$10 cents of
income per dollar
of asset
ROROA = 10%
Since it is all my money, then ROROE = 10%
Anatomy of Returns – Case 2
$1,000 of Total Assets (financed $700 by my
own money and $300 @8% borrowed from a
bank) generated $500 of total revenue, $400
of expenses before interest for $100 profit,
and $76 profits after interest expenses.
I leveraged someone else’s money
to increase the return to my money.
ROROE = 10.9%
76
700
My money
(Equity Capital)
=
$700
Total Assets
$300
Bank’s money
(Debt capital)
$1000
100
1000
=
$10.9 cents of income
per dollar of your
money
Before interest $.10 cents
of income per dollar of all
assets used.
ROROA = 10%
ROROA>i-rate The extra is payment to equity
10%
8% Thus 2% additional to Equity
Anatomy of Returns – Case 2
$1,000 of Total Assets (financed $700 by my
own money and $300 @8% borrowed from a
bank) generated $500 of total revenue, $400
of expenses before interest for $100 profit,
and $76 profits after interest expenses.
ROROA>i-rate Thus ROROE>ROROA (that’s good)
Return on equity capital
10% * $700
$70
Return on debt capital
(10%-8%) * $300
$6
Total return
$76
$76/$700 = 10.9% ROROE
Anatomy of Returns – Case 3
$1,000 of Total Assets (financed $700 by my
own money and $300 @8% borrowed from a
bank) generated $500 of total revenue, $500
of expenses before interest for $0 profit, and
-$24 profits after interest expenses.
ROROE = -3.4%
-24
700
My money
(Equity Capital)
=
-$3.4 cents of income
per dollar of your
money
=
Before interest $0 cents
of income per dollar of
all assets used.
$700
Total Assets
$300
Bank’s money
(Debt capital)
$1000
0
1000
ROROA = 0%
Making 0% on all assets, but paying 8%, and
the additional 8% is coming out of equity.
Anatomy of Returns – Case 3
$1,000 of Total Assets (financed $700 by my
own money and $300 @8% borrowed from a
bank) generated $500 of total revenue, $500
of expenses before interest for $0 profit, and
-$24 profits after interest expenses.
ROROA<i-rate Thus ROROE<ROROA (Not Good)
Return on equity capital
0% * $700
$0
Return on debt capital
(0%-8%) * $300
-$24
Total return
-$24
-$24/$700 = -3.4% ROROE
Anatomy of Returns – Case 4
$1,000 of Total Assets (financed $700 by my
own money and $300 @15% borrowed from a
bank) generated $500 of total revenue, $400
of expenses before interest for $100 profit,
and $55 profits after interest expenses.
ROROE = 7.9%
55
700
My money
(Equity Capital)
=
$700
Total Assets
$300
Bank’s money
(Debt capital)
$1000
100
1000
=
$7.9 cents of income
per dollar of your
money
Before interest $.10 cents
of income per dollar of all
assets used.
ROROA = 10%
Making 10% on all assets, but paying 15% on debt portion
(ROROA<i-rate), and the difference must come from equity.
Anatomy of Returns – Case 4
$1,000 of Total Assets (financed $700 by my
own money and $300 @15% borrowed from a
bank) generated $500 of total revenue, $400
of expenses before interest for $100 profit,
and $55 profits after interest expenses.
ROROA<i-rate Thus ROROE<ROROA (Not Good)
Return on equity capital
10% * $700
$70
Return on debt capital
(10%-15%) * 300 -$15
Total return
$55
$55/$700 = 7.9% ROROE
So, How Is Money Made?
• Through Three Primary Levers
– By being efficient with your operations
– By getting the most out of your assets
– By leveraging your money
• that is, helping your own money do bigger and
better things through borrowed use of someone
else’s money.
So, How Can I Analyze How I am
Doing At Making Money, Or
better yet how I might make
more money?
• By analyzing each of the three levers that
leads to Return on Equity – ROROE:
– Efficiency of operations
– How well assets are working into profits
– Leverage
Introducing the DuPont System
for Financial Analysis
DuPont System
• Developed in 1919 by a finance executive at E.I.
du Pont de Nemours and Co
• “The DuPont system is a way of visualizing the
information so that everyone can see it.”
(Stephen Jablonsky, Penn State University)
• DuPont analysis “is a good tool for getting
people started in understanding how they can
have an impact on results” (Doug McCallen,
Caterpillar Inc.)
• “Number one, it’s simple” (Sam Siegel, CFO)
DuPont System
• “DuPont Financial Analysis Model is a
rather straightforward method for
assessing the factors that influence a
firm’s financial performance.” (Gunderson,
Detre, and Boehlje, AgriMarketing 2005)
DuPont System – What is It?
•
The system identifies profitability as
being impacted by three different levers:
1. Earnings & efficiency in earnings Earnings
2. Ability of your assets to be turned into profits
Turnings
3. Financial leverage Leverage
DuPont System
Earnings/Efficiency
Operating
Profit Margin
Income
Stream
X
=
Asset
Turnover
Turnings/Asset Use
Investment
Stream
Financial
Structure
Leverage
Return On
Assets (less
interest adj.)
X
=
Return On
Equity
DuPont System Ratios
Earnings
Operating
Profit Margin
Income
Stream
X
interest adj.)
Asset
Turnover
Turnings
Investment
Stream
=
Return On
Assets (less
Financial
Structure
Leverage
X
=
Return On
Equity
Let’s Do The Math
DuPont System
Earnings/Efficiency
Operating
Profit Margin
X
=
Asset
Turnover
Turnings/Asset Use
Financial
Structure
Leverage
Return On
Assets (less
interest adj.)
X
=
Return On
Equity
Rate Of Return On Assets
NFIFO + interest paid - unpaid labor/mgt
ROROA =
Total Assets
Operating Profit Margin Ratio
NFIFO + interest pd – unpaid labor/mgt
Total Revenue
Asset Turnover Ratio
X
Total Revenue
Total Assets
DuPont System
Earnings/Efficiency
Operating
Profit Margin
X
=
Asset
Turnover
Turnings/Asset Use
Financial
Structure
Leverage
Return On
Assets (less
interest adj.)
X
=
Return On
Equity
Rate Of Return On Equity
NFIFO – unpaid labor/mgt
ROROE =
Total Equity
i-rate Adj.
Rate Of Return On Assets
NFIFO + interest pd. – unpaid labor/mgt
Total Assets
-
interest pd.
Total Assets
Leverage Ratio
=
NFIFO – unpaid labor/mgt
Total Assets
X
Total Assets
Total Equity
Net Farm Income From Operations
(NFIFO)
NFIFO = Total Revenue – Basic Costs – Non Basic Costs
sales, govt. pmts,
custom work +(-)
inventory changes
labor
+ depreciation
+ interest expenses
cash expenses
+(-) accrual expense changes
NFIFO = Total Revenue – COGS – Operating Expenses – Interest
Leverage is the mix of debt
versus equity capital used in
making profits.
- Do we have too much debt?
- Do we have enough debt?
- Is our debt capital generating
profits?
- Can our debt capital be put to
better use?
Leverage
Total Assets
Total Equity
Too Low
Return On
Assets
X
OK
=
Return On
Equity
Too Low
Total Revenue =
OK
cash income +(-) inventory changes
Basic Costs = cash expenses +(-) accrual exp changes + purch lstk Depr
Non Basic Costs = labor + depreciation + interest expenses
Earnings
NFIFO – unpaid labor/mgt + interest
Total Revenue
X
Turnings
Total Revenue
Total Assets
ATO
-Too much labor given output
- Not enough labor
-Training and Education
- Better systems and processes
- Weekly/Daily staff meetings
- Performance metrics
Leverage
Total Assets
Total Equity
OK
=
Too Low
OPMR
Return On
Assets
Too Low
OK
X
=
Return On
Equity
Too Low
Earnings
NFIFO – unpaid labor/mgt + interest
Total Revenue
X
Turnings
Total Revenue
Total Assets
ATO
-Unproductive machinery?
- Buildings not being used?
- Breeding livestock not producing?
- Unproductive land?
- Over valued assets?
Leverage
Total Assets
Total Equity
OK
=
OK
OPMR
Return On
Assets
Too Low
Too Low
X
=
Return On
Equity
Too Low
Also, selling off unproductive assets
and paying off debt could change
your leverage position in a positive
way, and also improve your ROROE!
Financial Diagnostics via DuPont.
Finding the Red Flags!
Prices
Production
Quality
Facilities
Processes
Operations
Health
Labor
Repairs
Timeliness
Management
Ability to
Manage
Assets
Revenues too
low for costs
OPM too
Low
Costs too high
for Revenues
ROROA
too Low
ATO too
Low
Obsolete or
Inefficient
Assets
Unused or
Under
Utilized
Assets
ROROE
too Low
Wrong Kind of
Debt
Leverage
Not Enough
Debt
End
http://cdp.wisc.edu/Management.htm
NFIFO
+int
- unpd mgt
31,157
1,665
÷
751,348
757,926
11.7
3.4
6.12
OPM
4.1%
0.2%
Earnings
GR
2007
2008
5 yr avg
Rate Of Return On Equity
NFIFO – unpaid labor/mgt
ROROE =
Total Equity
Rate Of Return On Assets
NFIFO – unpaid labor/mgt + interest pd.
ROROA =
Total Assets
Operating Profit Margin Ratio
NFIFO – unpaid labor/mgt + interest pd.
OPMR =
Total Revenue
Asset Turnover Ratio
Total Revenue
ATO =
Total Assets
Leverage Ratio
Total Assets
Financial Structure =
Total Equity