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An Overview Of Dupont Identity Finance Essay

DuPont system of financial analysis are developed in 1919 by a finance executive at E.I. du Pont de Nemours and Co., of Wilmington, Del., in the days when the chemical giant cooked up financial formulae as well as hydrocarbons, the DuPont system still helps many companies visualize the critical building blocks in return on assets and return on investments.

"The DuPont model is a way of visualizing the information so that everyone can see it," says accounting and Professor Stephen Jablonsky of Penn State University.

A typical DuPont chart resembles a chart drawn to mark the progress of competitors in a tennis or basketball tournament. Entries that ultimately make up before-tax return on investment include cost of goods sold, selling expenses, administrative expenses, inventories, accounts receivable and cash. At successive stages, they are added, subtracted, divided or multiplied until return on equity is reached.

In his book, The Manager's Guide to Financial Statement Analysis, Jablonsky stresses DuPont's enduring appeal. "Where financial people are integrated into the business,".

Outside the cloistered confines of finance departments, where financial performance has not taken root among rank-and-file workers, the DuPont model can be very effective. DuPont analysis "is a good tool for getting people started in understanding how they can have an impact on results," says Doug McCallen, budgets and forecasts manager at construction and mining equipment maker Caterpillar Inc., in Peoria, Ill., where performance has turned around since the company launched reorganization in 1991. That was the year it formally heightened focus on specific accountabilities for different parts of the business. "The DuPont model supports and reinforces those accountabilities," says McCallen.

Using return on assets as a primary performance measure and setting targets for each part of the organization, Caterpillar can determine when a problem is related to operating efficiency versus asset utilization. The results have been phenomenal, McCallen says. Return On Assets (ROA) has reached double digits, accompanied by record profits in 13 of 15 quarters, as of September 30.

Nucor Corp., a $4 billion-a-year producer of steel and steel products, has been using return on assets employed to measure performance in its facilities for years, with salutary results.

"Number one, it's simple," says Sam Siegel, vice chairman and chief financial officer of the Charlotte, N.C.-based company. "All of our people understand it." Each facility aims for a 25 percent or greater return on assets employed, which is calculated before the effects of federal income tax, interest expense and corporate overhead.

Thoughts from time to time about trading DuPont in for something else have yet to convince Siegel that something else is better. Alternatives, in his view, won't improve the company's incentives program. Nucor's overall profit-sharing plan is based on a 10 percent share of companywide pretax profits, and Siegel notes proudly that Nucor has consistently paid that amount into the plan since 1966, a year after new management took over after Martin Marietta sold its stake in the company.

The first re-engineer

The DuPont model of financial analysis was dreamed up by F. Donaldson Brown, an electrical engineer who joined the giant chemical company's treasury department in 1914. A few years later, DuPont bought 23 percent of the stock of General Motors Corp. and gave Brown the task of cleaning up the carmaker's tangled finances -- in effect, America's first large-scale re-engineering effort.

Much of the credit for GM's ascension afterward belongs to Brown's systems of planning and control, according to no less an expert than Alfred Sloan, GM's legendary chairman. Ensuing success launched the DuPont model to prominence in major U.S. corporations. It remained the dominant form of financial analysis until the 1970s.

Mix 'n match

The DuPont model falls short, say some critics, because it is not a great tool for predicting the future or for tracking costs. "It is designed to give you a picture of where you've put your resources," says Jack Kreischer, president of the Pennsylvania Institute of CPAs and managing director of Kreischer, Miller & Co., a public accounting firm in Horsham, Pa.

A DuPont model can tell you, for example, the extent to which you've invested in machinery to build widgets, but it offers little insight into growth prospects or costs along the way, Kreischer says. By the same token, DuPont lacks the means to include increasingly prominent intangible assets in its return calculations.

Flexibility, a hallmark of the expandable DuPont model, can enable finance executives to combine return on investment with measures that do incorporate growth prospects.

Some securities analysts routinely use DuPont in their state-of-the-art environment. "The DuPont method has the advantage of being much easier to use than other forms of analysis that depend on information buried in footnotes," says analyst Jim Stoeffel of Salomon Smith Barney in New York.

Nucor's decision to stick with DuPont reflects a pragmatic view of metrics. "I don't say it's the best way," Siegel concedes. "All I say is that it has worked for us."

Online source: http://www.bizlearning.net/news/news.cfm?newsitem=142

It was publish in the January 1998 issue of CFO magazine.

Section 3: Literature reviews

DuPont Identity

Usage of the DuPont Framework Application

Limitation of the DuPont Identity

Strength of the DuPont Identity

Usage of the DuPont Identity

These DuPont Identity can be used by the purchasing department and sales department. This system examines and demonstrates why a given Return On Asset (ROA) was earned. It also analyzes changes overtime. Besides that, these model teach people a basic understanding on how they can have an impact on company’s results. It shows the impact of professionalizing the purchasing function.

Strength of the DuPont Identity

Simplicity. A very good tool to teach people a basic understanding how they can have an impact on results.

Can be easily linked to compensation schemes.

Can be used to convince management that certain steps have to be taken to professionalize the purchasing or sales function. Sometimes it is better to look into your own organization first. Instead of looking for company takeovers in order to compensate lack of profitability by increasing turnover and trying to achieve synergy.

Limitation of the DuPont Identity

Based on accounting numbers, which are basically not reliable.

Does not include the Cost of Capital.

Garbage in, garbage out.

Online source: http://www.12manage.com/methods_dupont_model.html

Basic DuPont Identity Equations

( Part 1)

THE DUPONT MODEL - RETURN ON EQUITY

Analyzing the Three Components of Return on Equity:

Return On Equity (ROE) is one of the most important indicators of a firm’s profitability and potential growth. Companies that boast a high return on equity with little or no debt are able to grow without large capital expenditures, allowing the owners of the business to withdrawal cash and reinvest it elsewhere. Many investors fail to realize, however, that two companies can have the same return on equity, yet one can be a much better business.

For that reason, according to CFO Magazine, a finance executive at E.I. du Pont de Nemours and Co., of Wilmington, Delaware, created the DuPont system of financial analysis in 1919. That system is used around the world today and will serve as the basis of our examination of components that make up return on equity.

Calculation of Return on Equity

To calculate the return on equity using the DuPont model, simply multiply the three components (net profit margin, asset turnover, and equity multiplier.)

Return on Equity = (Net Profit Margin) (Asset Turnover) (Equity Multiplier).

Composition of Return on Equity using the DuPont Model:

There are three components in the calculation of return on equity using the traditional DuPont model; the net profit margin, asset turnover, and the equity multiplier. By examining each input individually, we can discover the sources of a company's return on equity and compare it to its competitors.

Net Profit Margin

The net profit margin is simply the after-tax profit a company generated for each dollar of revenue. Net profit margins vary across industries, making it important to compare a potential investment against its competitors. Although the general rule-of-thumb is that a higher net profit margin is preferable, it is not uncommon for management to purposely lower the net profit margin in a bid to attract higher sales. This low-cost, high-volume approach has turned companies such as Wal-Mart and Nebraska Furniture Mart into veritable behemoths.

Two ways to calculate net profit margin:

Net Income ÷ Revenue

Net Income + Minority Interest + Tax-Adjusted Interest ÷ Revenue.

Whichever equation you choose, think of the net profit margin as a safety cushion; the lower the margin, the less room for error. A business with 1% margins has no room for flawed execution. Small miscalculations on management’s part could lead to tremendous losses with little or no warning.

Asset Turnover

The asset turnover ratio is a measure of how effectively a company converts its assets into sales. It is calculated as follows:

Asset Turnover = Revenue ÷ Assets

The asset turnover ratio tends to be inversely related to the net profit margin; i.e., the higher the net profit margin, the lower the asset turnover. The result is that the investor can compare companies using different models (low-profit, high-volume vs. high-profit, low-volume) and determine which one is the more attractive business.

Equity Multiplier

It is possible for a company with terrible sales and margins to take on excessive debt and artificially increase its return on equity. The equity multiplier, a measure of financial leverage, allows the investor to see what portion of the return on equity is the result of debt. The equity multiplier is calculated as follows:

Equity Multiplier = Assets ÷ Shareholders’ Equity.

Basic DuPont Identity Equations

( Part 2)

Return On Assets (ROA)

Return On Assets sometime called Return On Investment (ROI). It compares income as a percentage of total investment. It is a basic measure of profitability of a company; profit margin and efficiently of a company manages its assets; total assets turnover.

Return On Assets Formula:

Return On Assets (ROA) = Profit Margin X Total Assets Turnover

Return On Assets (ROA) = ( Net Income / Sales) X ( Sales / Total Assets)

These equation divides this into two factors; which are profit margin and asset turnover. It illustrates both profitability of operations (profit margin) and efficient use of assets (turnover).

Return On Equity (ROE)

Return on Equity (ROE) measures of profitability on assets actually provided by owners of a company.

Return On Equity Formula:

Return On Equity (ROE) = Return On Assets (ROA) X Equity Multiplier

Return on Equity (ROE) = Profit Margin X Total Assets Turnover X (Total Assets / Stockholder Equity)

DuPont System Analysis

These system analytical method that uses the balance sheet and income statement to break the Return On Assets(ROA) and Return On Equity (ROE) ratios to component pieces. It’s objective is to find out why a company’s profitability, as measured by ROA and ROE, is higher or lower than the industry average ROA or ROE or last year’s company ROA or ROE.

Equity Multiplier

Assets Management Ratios

Liquidity Ratios

Total Asset Turnover

Taxes to Sales

Interest expense to Sales

Cost of goods sold to Sales

Basic Earning Power

Profit Margin

ROA

Return On Assets

ROE

Return On Equity

Step in the DuPont System Analysis Process

Collect the business numbers (from the finance department).

Calculate (use a spreadsheet).

Draw conclusions.

If the conclusions seem unrealistic, check the numbers and recalculate.

Example of DuPont System Analysis

“Company A” wanted to grow fast and was able to grow ever faster than its planned growth rate. This is because of its profitability as measured by ROE was higher than expected.

“Company A” has Net Profit Margin of 7%, Total Assets of Turnover of 2, Equity Multiplier of 1.5

“Company B” has Net Profit Margin of 8%, Total Asset of Turnover of 1.5, and Equity Multiplier of 1.25

Format to show your DuPont analysis:

Company

ROE

Net Profit Margin

Total Asset Turnover

Equity Multiplier

Company A

21.0%

7%

2

1.5

Company B

15.0%

8%

1.5

1.25

As a conclusion, “Company A” has a much better ROE than its industry because its use of assets is more efficient (it generates more sales per dollar of asset investment) and it uses more debt financing. “Company A” pricing and expense control are inferior to the industry, however, and the use of debt constitutes a greater risk for “Company A” because it may not be able to handle the interest payments and principal repayment.

Section 4: Analyses/discussions

Problem Solving for DuPont Identity

Question 1:

If Silas 4- Wheeler, Inc. has an Return On Equity (ROE) of 18 percentage, equity multiplier of 2, a profit margin of 18.75 percentage, what is the total assets turnover ratio and capital intensity ratio?

Information given:

Return On Equity (ROE) = 18% or 0.18

Equity Multiplier =2

Profit Margin = 18.75 % or 0.1875

Find:

Total Assets Turnover Ratio

Capital Intensity Ratio

Solution for (i):

Return On Equity (ROE) = Return On Assets (ROA) X Equity Multiplier

Return On Equity (ROE) = Profit Margin X Total Assets Turnover X Equity Multiplier

0.18 = 0.1875 X Total Assets Turnover X 2

Total Assets Turnover = 0.48 times.

Solution for (ii):

Capital Intensity Ratio = 1/ Total Assets Turnover

Capital Intensity Ratio = 1/ 0.48

Capital Intensity Ratio = 2.0833 times.

Question 2:

Last year Hassan’s Madhatter, Inc. had an Return On Assets(ROA) of 7.5 %, a profit margin of 12 percentage, and sales of RM 10,000,000. Calculate Hassan’s Madhatter’s total assets.

Information given:

Return On Assets(ROA) = 7.5 % or 0.075

Profit Margin = 12 % or 0.12

Sales = RM 10,000,000

Find company’s total assets.

Solution:

Return On Assets (ROA) = Profit Margin X Total Assets Turnovers

Return On Assets (ROA) = (Net Income / Sales) X ( Sales / Total Assets)

0.075 = 0.12 X (RM 10,000,000 / Total Assets)

Total Assets: RM 16,000,000.

Source: Marcia Millon Cornett , Troy A.Adair ,Jr. , John Nofsinger, Finance Applications and Theory International Ed.

(Book)

Conclusions & Suggestion

The “really” modified Du Pont model of ratio analysis can show up relatively complex financial analysis and put strategic financial planning at the fingertips of any small business owner or manager who takes the relatively little time needed to understand it. Each operating and financial decision can be made within a framework of how that decision will impact return on equity (ROE). Easily set up on a computer model one can see how decisions “flow through” to the bottom line, which facilitates coordinated financial planning. (Harrington & Wilson, 1986).

In its simplest form, we can say that to improve ROE the only choices one has are to increase operating profits, become more efficient in using existing assets to generate sales, recapitalize to make better use of debt and/or better control the cost of borrowing, or find ways to reduce the tax liability of the firm. Each of these choices leads to a different financial strategy.

For example, to increase operating profits one must either increase sales or reduce expenses. Since it is generally more difficult to increase sales than it is to reduce expenses, a small business owner can try to lower expenses by determining: (1) if a new supplier might offer equivalent goods at a lower cost, or (2) if a website might be a viable alternative to a catalog, or (3) can some tasks currently being done by outsiders be done in-house. In each case net income will rise without any increase in sales and return on equity (ROE) will rise as well.

Alternatively, to become more efficient, one must either increase sales with the same level of assets or produce the same level of sales with less assets. A small business owner might then try to determine: (1) if it is feasible to expand store hours by staying open later or on weekends, or (2) if a less expensive piece of equipment is available that could replace an existing (more expensive) piece of equipment, or (3) if there is a more practical way to produce and/or deliver goods or services than is presently being used.

Further, small business owners can determine if they are using debt wisely. Refinancing an existing loan at a cheaper rate will reduce interest expenses and, thus, increase ROE. Exercising some of an unused line of credit can increase the financial structure ratio with a corresponding increase in ROE. And, taking advantage of tax incentives that are often offered by federal, state, and local taxing authorities can increase the tax effect ratio, again with a commensurate increase in ROE.

In conclusion, ROE is the most comprehensive measure of profitability of a firm. It considers the operating and investing decisions made as well as the financing and tax-related decisions. The “really” modified Du Pont model dissects ROE into five easily computed ratios that can be examined for potential strategies for improvement. It should be a tool that all business owners, managers, and consultants have at their disposal when evaluating a firm and making recommendations for improvement.

Conclusion

Experiences and Knowledge’s Gained

It is undeniable that we get to learn abundant of knowledge which is far out from the book by experiencing and seeing it by ourselves. This is the time where the students are able to integrate all the theories which had been learned at university into practical. It was really a good experience since we can learn how to communicate well with other group members and exchange new ideas and the most importance thing is we learned to respect the entire group member. From here we have learned to analysis and solve problem, organizing work and writing reports.

Teamwork

Through this assignment, we realize the importance of working in groups, especially while facing with problem. Working in group allows more ideals to be generated and each of group members will co-operate among each other in order to finish the tasks assigned. Having the opportunity to work together with group member, we have the chance to improve our communication skills. As everyone is under the same group with the same mission and vision, we need to interact and co-operate with each others to resolve the difficulty that we faced.

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