Providing Students with an Overview of Financial Statements Using

the Dupont Analysis Approach

Dr. Gene Milbourn, University of Baltimore, Maryland
Dr. Tim Haight, California State University, Los Angeles, CA


ABSTRACT

This paper uses the Dupont Analysis as a teaching aid to equip students with an understanding of how
management decisions influence the bottom line. This simplified approach allows students to see the big picture
and to logically follow how management decisions affect components that contribute to firms performance. As such
it can be a valuable tool in building a students critical thinking competencies in evaluating the health, prospects and
valuations of companies.

INTRODUCTION

The volume of information contained in the balance sheet and income statement often overwhelms students
in an introductory finance class. While basic accounting classes prepare students in the preparation of financial
statements, finance classes typically focus on their interpretation to aid in decision-making. Unfortunately, entering
students are often lost in the detail and are unable to see the forest for the trees.

The ultimate goal is for students to understand the interrelationships between financial statements and how
management decisions affect firms performance. To be sure, our future managers must fully understand the
financial consequences of all the decisions and how these decisions affect the bottom line.

Fortunately, there is a very powerful financial tool to assist students in understanding the ramifications of
decisions on profitability. The Dupont Analysis is a measurement instrument that can provide students with several
insights into key factors that contribute to bottom line performance. This tool is used to evaluate a firms financial
condition by comparing relationships within the income statement and balance sheet, or between the two statements.

The Dupont Analysis provides information on the firms liquidity, profitability, efficiency, and leverage
status, thus allowing students to see how well a firm is operating as a result of changes in one or more of these
factors. It is a very powerful tool that allows one to trace the financial impact of decisions and to understand the
interrelationship between the income statement, balance sheet and firm profitability

RETURN ON ASSETS: THE OPERATING INCOME VIEW

Dupont analysis begins by using the firms return on assets (ROA). Return measures can either be on a
before-tax or an after-tax basis. Here, we will illustrate return using ROA, an after tax measure which is defined as
follows:
ROA = Net Income After Taxes (NIAT) {equation 1}
Assets (invested capital)

ROA measures the firms profits as a percent of its assets. Note that ROA increases if any one of the three
following factors changes while the other two remain the same:

if costs decrease, income increases, so ROA increases;
if revenue increases, income increases, so ROA increases;
if assets decrease, ROA increases.

Students can quickly gain an understanding of how any of these changes affect return. To provide a context
for classroom discussion, the instructor will evaluate a firms performance, ROA with either an industry average or
the firms historic returns. If the firm has higher ROA than the industry, the firm is more profitable. Similarly, if the
firms ROA is lower than the industrys it is viewed as less profitable.






The Journal of American Academy of Business, Cambridge * March 2005 46
DUPONT ANALYSIS: BREAKING ROA DOWN INTO TWO ELEMENTS

In Dupont analysis, the ROA is expanded and broken down into two components:

ROA = NIAT/ Revenue X Revenue/Assets {equation #2}

Where:
Revenue/Assets = Asset turnover (measure of resource efficiency)
and
NIAT/Revenue = Net Profit Margin (profits related to sales generated)

Thus, Dupont analysis translates the basic ROA ratio into the following:

ROA = Asset Turnover x Net Profit Margin {equation 2}

These two sub-measures are useful in the following way:
Asset turnover measures the efficiency of the firms assets. The higher this ratio, the more efficient the assets.
Operating profit margin is an indicator of the firms profitability as it relates to revenue.

These two measures, when combined, permit students to see the relative contributions of asset efficiency
and profitability on the firms Return on Assets.

The use of the Dupont System to investigate firm performance can employed on a time series basis or as
part of a cross sectional analysis within a given industry or sector. Typically, a firm can isolate the causes of
deteriorating ROA over time by separating the relative impact of its asset turnover and profit margin during the
period under investigation. Once the source of the deteriorating ROA is isolated, firms can then focus on the area
suggested by the Dupont System. Often changes in firms performance are a result of external factors that may be
affecting the entire industry and/or sector within the industry. Here, cross sectional analysis can be employed to
ascertain whether performance problems are isolated within the firm or are being experienced by competitors as
well.

ILLUSTRATION

The analysis below will investigate the relative firm performance of two firms within a hypothetical
industry. The Dupont Analysis is illustrated using the income statements and balance sheet statements of firms A
and B in Table 1 and Table 2. For this illustration we will assume that accounting treatment of such items, as
depreciation and inventory valuation are consistent. Each firm is examined on the basis of ROA and compared to its
industry norm in Table 3. The Dupont analysis is then used to examine the relative contributions of the efficiency
and profitability components to each firms ROA to understand in greater depth the key factors affecting the firms
performance.

Table 1 Firms A and B: Income Statements
A B
Sales $550,000 $600,000
Cost of Goods Sold 305,000 400,000
Gross profits $245,000 $200,000

General & Administrative 110,000 95,000

Net Operating Income $135,000 $105,000
Interest expense 7,500 10,000
Earnings before taxes $127,500 $95,000
Taxes (40%) 51,000 38,000

Net Income After Taxes (NIAT) $ 76,500 $ 57,000

*Analysis assumes a 40% marginal tax rate







The Journal of American Academy of Business, Cambridge * March 2005 47
COMPARISON OF FIRM A VS. FIRM B

Using Equation 1 (ROA = NIAT/Assets) and the information contained in Tables 1 and 2, the ROA for
firms A and B is calculated as follows:

Firm A:
ROA = $ 76,500/$412,500 = 18.55%

Firm B:
ROA = $ 57,000/$396,000 = 14.39%

In terms of ROA, Firm A appears to be more profitable than Firm B with a ROA of 18.55%
vs.14.39% for Firm B.

Table 2 Firms A and B: Balance Sheets
A B
Assets
Cash $ 10,000 $ 9,000
Accounts Receivable 85,000 95,000
Inventory 67,500 97,000
Current assets $162,500 $201,000
Plant and equipment (net) 250,000 195,000
Total assets $412,500 $396,000

Liabilities and net worth
Notes payable $ 2,000 $ 3,100
Accounts payable 58,000 63,000
Accrued taxes 7,500 8,900
Total current liabilities $67,500 $ 75,000

Long-term debt $ 100,000 $ 125,000
Capital stock $ 75,000 $ 75,000
Retained earnings $170,000 $121,000
Total liabilities and net worth $412,500 $396,000


INDUSTRY COMPARISON USING THE DUPONT ANALYSIS

Now let us compare their performance with that of the industry that is reported in Table 3. As the table
reveals, the industry average ROA is 16.8% In comparison to this performance measure, firm As return (18.55%)
exceeded the industry norm while Firm Bs return (14.39%) fell short.

What contributed to Firm A exceeding the industry average while Firm B performed below the industry
benchmark? To answer this question we can turn to the Dupont Analysis. Using equation #2, ROA is subdivided
into the asset turnover ratio and the net profit margin components.

Table 3 Comparative Ratios
Ratio* Firm A Firm B Industry
Net Profit Margin 13.91% 9.50% 12.0%
Revenue/ Assets 1.33x** 1.52x 1.40.x
Return on Assets 18.55% 14.39% 16.8%
Current Assets/Current Liabilities 2.40 2.68 2.50
Average Collection Period 56days 57 days 60 days
Cost of Goods Sold/Inventory 4.52x 4.12x 4.00x
* Firms A and B ratios are calculated from Tables 1 and 2, while the industry percentages are given.
** x indicates times.

DUPONT ANALYSIS OF INDUSTRY

As reported in table 3, the industrys ROA can be expanded as:

ROA = Asset Turnover X Net Profit Margin
16.8% = 1.40 X 12%



The Journal of American Academy of Business, Cambridge * March 2005 48
Dupont analysis reveals that the industrys 16.8% return on assets is the result of an asset turnover of 1.40
and a net profit margin of 12%.

DUPONT ANALYSIS OF FIRM A

Now that the relationship of asset efficiency and profitability has been identified on an industry level, the
same technique can be used to examine the individual firms return components. The application of the Dupont
technique to Firm A yields the following:

NIAT = Revenue X NIAT
Assets Assets Revenue

$76,500 = $550,000 X $ 76,500
$412,500 $412,500 $550,000

18.55% 1.33 X 13.91%

These results can now be compared with the industry results. The analysis shows that firm As asset
turnover (1.33) was below the industry average (1.40), while its net profit margin (13.9%) was above that of the
industry (12%). Thus, Firm As superior performance was due to its higher profit margin than the industry average
(i.e., 13.91% versus 12%) despite having a lower turnover.

Firm As performance is impressive. It would be even more impressive if the firm could maintain its profit
margin and increase its asset turnover to the industrys level. We can use equation 2 to calculate Firm As ROA
under this assumption. This yields the following result:

ROA = Asset Turnover X Net Profit Margin
19.47% = 1.40 X 13.91%

At this point, it may be useful to have the students focus on the firms asset turnover ratio. Students will
easily recognize that:

the firm can increase revenue while maintaining its present asset level or;
the firm can reduce the amount of assets employed at its existing revenue level.

Regardless of which path is chosen the analysis shows the direction in which further examination should
proceed. In this case, it appears that the firms investment in assets may be excessive.

DUPONT ANALYSIS OF FIRM B

The same approach can be used for Firm B to reveal why its performance is low relative to the industry.
Here, Dupont Analysis yields the following:

NIAT = Revenue X NIAT
Assets Assets Revenue

$ 57,000 = $600,000 X $ 75,000
$396,000 $396,000 $600,000

14.39% = 1.52 X 9.50%

Dupont analysis shows that Firm Bs asset turnover (1.52) is well above the industry average (1.4), while
its net profit margin (9.5%) is much lower than that of the industry (15%). Thus, Firm Bs sub par performance is
due to its low net profit margin. Firm Bs Return on assets would have been even lower without its high resource
utilization as measured by the asset turnover. Again returning to the Dupont Analysis, lets assume that firm
maintains its asset turnover and achieves the industry averages net profit margin of 12.0%. The results are as
follows:
ROA = Asset Turnover X Net Profit Margin
18.24% = 1.52 X 12.0%



The Journal of American Academy of Business, Cambridge * March 2005 49
Thus, Firm B would increase its ROA to 18.24 percent by increasing its profit margin to the industrys
average. Here again, the students should focus on the firms net profit margin. Should the firm increase prices,
decrease costs, or both? Will the environment that the firm operates in allow for price increases? Can the firm
become more efficient? Again, the framework for the discussion revolves around the Dupont Analysis.

SUMMARY OF VARIANCES FOR FIRMS A AND B COMPARED TO THE INDUSTRY

For both firms, Dupont Analysis reveals that their variance in return was attributed to both the asset
turnover and the profit margin components. In the case of Firm A, its asset turnover was below the industry average
while its net profit margin was above the industry average. For Firm B, the opposite is true. They outperformed the
industry in terms of asset turnover, but under performed on the basis of profit margins. However, in both instances
the Dupont Analysis provided direction into the examination of performance causes.

Using Dupont Analysis for Scenario Planning
Dupont Analysis can also be useful as a planning tool. This approach allows students to explore how
various scenarios affect ROA in terms of asset efficiency and profit margins. The impact of pricing decisions,
increased expenses, and asset investment can be viewed based on its expected impact on asset returns. Thus, Dupont
Analysis can be a useful planning aid as well as a diagnostic tool. To illustrate this point, consider Firm Bs current
return on asset performance. The breakdown of its return on assets is reproduced below:

ROA = Asset turnover X Net Profit margin
18.55% 1.33 X 13.91%

Assume that management believes that it can increase its net profit margin from 13.91% to 14% by
shipping directly from its foreign suppliers to its customers bypassing its current warehouse. Furthermore, lets
assume that if the existing supply-chain is altered, management also expects that its investment in inventory will
decrease, increasing its asset turnover from 1.33 to 1.40. Finally, management expects revenue to remain the same.
How will this affect the firms return on assets? Dupont analysis can be used to calculate the expected ROA. The
calculations would be as follows:

Projected ROA = 1.40 X 16.0% = 22.4%

Under this scenario, ROA might increase from 18.55% to 22.4%. Thus, from a return on asset view, the
new supply chain strategy should be explored. Additional analysis would be required before ultimately going
forward, but its likely impact on ROA as shown above, can be easily ascertained. Many other financial issues can
be addressed using Dupont Analysis.

SUMMARY

The Dupont Analysis provides students with the framework to understand how decision-making affects the
bottom line. Using this approach, students can gain a better appreciation of the interrelationship between the income
statement and balance sheet, without getting bogged down in the details. Teaching financial analysis using this
approach will assure the critical thinking skills that will better prepare students to be effective managers.

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