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 banks 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 elses money to increase the return to my money. My money (Equity Capital) ROROE = 10.9%

76 700 $700 $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%

Total Assets

$300
Banks money (Debt capital)

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 (thats good) Return on equity capital 10% * $700 $70 Return on debt capital (10%-8%) * $300 $6 Total return $76/$700 = 10.9% ROROE $76

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% My money (Equity Capital)

-24 700 $700 $1000 0 1000

-$3.4 cents of income per dollar of your money Before interest $0 cents of income per dollar of all assets used. ROROA = 0%

Total Assets

$300
Banks money (Debt capital)

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/$700 = -3.4% ROROE -$24

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% My money (Equity Capital)

55 700 $700 $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%

Total Assets

$300
Banks money (Debt capital)

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/$700 = 7.9% ROROE $55

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 elses 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, its simple (Sam Siegel, CFO)

DuPont System
DuPont Financial Analysis Model is a rather straightforward method for assessing the factors that influence a firms 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 = Return On Assets (less interest adj.) X = Return On Equity

Asset Turnover
Turnings/Asset Use

Investment Stream

Financial Structure Leverage

DuPont System Ratios

Earnings

Operating Profit Margin

Income Stream X = Return On Assets (less
interest adj.)

Asset Turnover
Turnings

Return On Equity

Investment Stream

Financial Structure Leverage

Lets Do The Math

DuPont System
Earnings/Efficiency

Operating Profit Margin

X = Return On Assets (less interest adj.) X = Return On Equity

Asset Turnover
Turnings/Asset Use

Financial Structure Leverage

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

Total Revenue Total Assets

DuPont System
Earnings/Efficiency

Operating Profit Margin

X = Return On Assets (less interest adj.) X = Return On Equity

Asset Turnover
Turnings/Asset Use

Financial Structure Leverage

Rate Of Return On Equity

NFIFO unpaid labor/mgt

ROROE = Total Equity

Rate Of Return On Assets NFIFO + interest pd. unpaid labor/mgt Total Assets

i-rate Adj.

interest pd. Total Assets

Leverage Ratio

NFIFO unpaid labor/mgt Total Assets

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.

Return On Assets

OK

- 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?

Return On Equity

Too Low

Leverage

Total Assets Total Equity

Too Low

Total Revenue =

cash income +(-) inventory changes

OK

Basic Costs = cash expenses +(-) accrual exp changes + purch lstk Depr Non Basic Costs = labor + depreciation + interest expenses NFIFO unpaid labor/mgt + interest Total Revenue OPMR

Earnings

Too Low Too Low

X
Turnings Total Revenue Total Assets ATO

Return On Assets

OK
Return On Equity

-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

Too Low

OK

Earnings

NFIFO unpaid labor/mgt + interest Total Revenue

OPMR

OK Too Low

X
Turnings Total Revenue Total Assets ATO

Return On Assets

Too Low
Return On Equity

-Unproductive machinery? - Buildings not being used? - Breeding livestock not producing? - Unproductive land? - Over valued assets?

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!

Leverage

Total Assets Total Equity

OK

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 ATO too Low Obsolete or Inefficient Assets Unused or Under Utilized Assets ROROA too Low

Wrong Kind of Debt

Leverage Not Enough Debt

ROROE too Low

End
http://cdp.wisc.edu/Management.htm

NFIFO +int - unpd mgt 31,157 1,665 751,348 757,926 GR

11.7 3.4 6.12 OPM 4.1% 0.2% Earnings

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