Dupont Analysis and Strategy
P.V. Viswanath
Financial Theory
and
Strategic Decision-Making
Standard Dupont Analysis
ROA = NI/TA
= (NI/Sales) x (Sales/TA)
= (Net Profit Margin) x (Asset Turnover)
ROE = NI/TE = ROA x (TA/TE)
= (NI/Sales) x (Sales/TA) x (TA/TE)
= Net Profit Margin x Asset Turnover x Equity Multiplier
Blunt instrument to monitor strategy because
The denominator in the ROA includes assets claimed by
all providers of capital, while the numerator includes only
return to providers of equity.
Assets include operating assets and financial assets
Net income includes income from operating activities, as
well as interest income and expense, which are the
consequence of financial decisions.
Alternative Decomposition
The key is to divide assets into operating assets and non-operating
assets, and similarly the liabilities into those associated with the firm’s
operations and those that are not.
Some of the firm’s long-term liabilities are non-interest bearing, such
as pension obligations, which are really part of the firm’s operations
rather than its financing.
We net the firm’s long-term assets net of these non-interest bearing
liabilities to get Net long-term assets.
Similarly, we would like to create a category of short-term assets that
includes all short operating assets, net of all short-term operating
liabilities. This gives us Operating Working Capital, defined as
(Current Assets – Cash and Marketable Securities) – (Current
Liabilities – Short term debt and current portion of long-term debt).
Net Assets = Net long-term assets + Operating Working
Capital
Net Debt = Total interest bearing liabilities – Cash and
Marketable Securities
(Cash is treated as negative debt, which is debatable.)
Alternative Decomposition
Similarly, we isolate and use net operating
profit, rather than using Net Income (which
includes interest).
This is done by adding back interest expense to
net income, after adjusting for their tax impact.
Similarly, interest income.
Thus, we first define (NIntAT) Net Interest
expense after tax as (Interest expense –
Interest Income)x(1-Tax rate).
Then Net Operating Profit After Taxes (NOPAT)
= Net Income + Net Interest Expense after
taxes; and Net Income = NOPAT – NIntAT.
Alternative Decomposition
ROE = (NOPAT/Equity) – (NIntAT /Equity)
= (NOPAT/Net Assets) x (Net Assets/Equity) –
(NIntAT)/Net Debt) x (Net debt/Equity).
If we rewrite Net Assets as Net Debt + Equity, we get
the following:
ROE = (NOPAT/Net Assets) x (1+Net Debt/Equity) –
NIntAT/Net Debt x (Net debt/Equity).
Defining NOPAT/Net Assets as Operating ROA and
combining terms with NIntAT/Net Debt (which is the
effective interest rate after tax on debt), we get
ROE = Op ROA + (Op ROA – Eff Int Rate after tax) x
(Net Debt/Equity)
=Op ROA + (Op ROA – Eff Int Rate after tax) x Net fin
leverage
= Op ROA + Spread x Net financial leverage
Alternative Decomposition
Since we are primarily interested in
using the Dupont decomposition to help
us in operating decisions, we can
further decompose Operating ROA.
Operating ROA = NOPAT/Sales x
Sales/Net Assets or
Operating ROA = NOPAT Margin x
Operating Asset Turnover
Dupont Analysis Applied
We now try to relate Dupont Analysis to
more specific operating strategies of the
firm.
In this process, we will have to extend
the Dupont decomposition even further.
Five Generic Competitive Strategies
Type of Competitive Advantage Being Pursued
Broad CrossSection of
buyer
Lowest Cost
Differentiation
Overall Low-Cost
Provider Strategy
Broad
Differentiation
Strategy
Best-Cost
Provider
Strategy
Market
Target
Narrow
Buyer
Segment
Focused Low-Cost
strategy
Focused
Differentiation
Strategy
How to Produce Cost Advantages
Perform value chain activities more costeffectively than rivals
Economies of scale; manifests itself in lower
COGS/Assets ratio – (better asset utilization)
Cost efficient supply-chain management
Reduce inventory costs – (lower assets)
Use online systems to achieve operating
efficiencies (better COGS/Asset)
Revamp the firm’s overall value chain to
eliminate or bypass some cost-producing
activities altogether (e.g. outsourcing)
Corporate Examples
WalMart: streamlining orders, automation of
distribution centers
Nucor Corporation: Using relatively inexpensive
electric arc furnaces where scrap steel and
directly reduced iron ore are melted. Makes
the use of coal, coke and iron ore unnecessary;
cuts investment in facilities and equipment
(eliminating coke ovens, blast furnaces, basic
oxygen furnaces, and ingot casters).
Southwest Airlines: no inflight meals, assigned
seating; fast online reservation system;
automated check-in equipment
Q: How do these activities affect the income
statement and the balance sheet?
Differentiation Strategies
Incorporate Product attributes and user
features that lower the buyer’s overall cost
of using the product.
Incorporate features that raise product
performance.
Incorporate features that enhance buyer
satisfaction in noneconomic or intangible
ways.
Differentiate on the basis of competencies
and competitive capabilities that rivals
don’t have or can’t afford to match
How to Differentiate
Product R&D activities – improved product
design and performance features; e.g. Volvo or
BMW
Supply Chain activities that affect the
performance or quality of the company’s end
product. Starbucks has a better product because
it has strict specifications on the coffee beans.
Marketing, sales and customer service activities
that result in superior technical assistance to
buyers, faster maintenance and repair services,
more and better product information for
customers, more and better training materials for
end users, better credit terms, quicker order
processing etc.; e.g. Maytag
Low Cost Provider Strategy
Striving to achieve lower overall costs
than rivals and appealing to a broad
spectrum of customer, usually by
underpricing rivals.
Marketing Tactic: Low Price
Operating Tactic: Economies of Scale
Broad Differentiation Strategy
Seeking to differentiate the company’s
product offering from rivals’ in ways
that will appeal to a broad spectrum of
buyers.
Marketing Tactic: General Advertising –
need to reach a broad audience; this
could be broken down by advertising
channel. Higher expenditures on
general TV ads, relatively fewer on
direct marketing.
Operating Tactic: Product R&D
Best-Cost Provider Strategy
Giving customers more value for the
money by incorporating good-toexcellent product attributes at a lower
cost than rivals. The objective is to
have the lowest costs and prices
compared to rivals offering products
with comparable attributes.
Marketing Tactic: Direct marketing
Operating Tactic: R&D, efficient use of
working capital
Focused Low-Cost Strategy
Concentrating on a narrow buyer
segment and outcompeting rivals by
having lower costs than rivals and thus
being able to serve niche members at a
lower price.
Marketing Tactic: Direct Marketing
Operating Tactic: Efficient use of
working capital
Focused Differentiation Strategy
Concentrating on a narrow buyer
segment and outcompeting rivals by
offering niche members customized
attributes that meet their tastes and
requirements better than rivals’
products.
Marketing Tactic: Direct Marketing
Operating Tactic: R&D
Five Generic Competitive Strategies
Type of Competitive Advantage Being Pursued
Broad CrossSection of
buyer
Market
Target
Lowest Cost
Differentiation
Overall Low-Cost
Provider Strategy
Low Price
Economies of
Scale
Broad
Differentiation
Strategy
Gen Advtg
Product R&D
Best-Cost
Provider
Strategy
Direct Mktg
R&D, efficient
use of wkg cap
Narrow
Buyer
Segment
Focused Low-Cost
strategy
Direct Mktg
Efficient use of
Focused
Differentiation
Strategy
Direct Mktg
Five Generic Competitive Strategies
Type of Competitive Advantage Being Pursued
Broad CrossSection of
buyer
Market
Target
Lowest Cost
Differentiation
Overall Low-Cost
Provider Strategy
Wal-Mart, 99
Cent Stores,
Dollar Tree
Broad Differentiation
Strategy
Starbuck’s, Land’s
End, Victoria’s
Secret
Best-Cost
Provider
Strategy
UPS,
Budweiser
Narrow Buyer Focused LowSegment
Cost strategy
Dairy Queen,
Tabasco
Focused
Differentiation
Strategy
Trader Joe’s, Microbreweries
Five Generic Strategies
Strategy
Cost
Price
Quality Margin
Volume
Low-cost
provider
strategy
Low
Low
Low
Low
High
Broad
differentiation
strategy
Medium
High
High
High
High
Best-cost
provider
strategy*
Focused low
costs
strategy
Low-toMedium
Medium
-to-high
Higher
Low-tomedium
Mediumto-high
Low
Low
Low to
medium
Low
Mediumto-High
Focused
differentiation
strategy
medium
Medium
-to-high
Medium
Medium
Low
Marketing
Tactic
Low Price
Branding;
General
Advertising;
moderately high
mktg costs
Direct
Marketing; low
marketing costs
Direct Marketing
Direct marketing
Operating
Tactic
Economies of
Scale; high
working capital
utilization; high
fixed asset
utilization
R&D
R&D, efficient
use of working
capital
high working
capital
utilization;
moderately high
fixed asset
utilization
R&D
Ratio
Higher Sales/Net
Working Capital;
Higher
COGS/Assets
Higher
R&D/Sales;
lower Sales/AR;
high advertising
expenses/Sales
Moderate
COGS/Assets,
Sales/A/R may
not be high
but Sales/Assets
are still relatively
high
High Direct
Mktg/Sales ratio;
high R&D/Sales
A further decomposition?
If we separate Net Income into Sales –
COGS – Direct Marketing expenses –
General Advertising Expenses – Other
expenses, we can write ROA as:
Sales/Assets x [1-DME/Sales-GAE/SalesOther expenses/Sales] – COGS/Assets.
The inverse of Sales/Assets can be
written as (NWC + Net Long-term
Assets)/Sales and NWC can be further
broken down, if necessary.