## Friday, 27 January 2017

### Du Pont Analysis Simplified with an Example

The simplified formula for Du Pont analysis is shown below.

Before we go deeper we need to clarify each term used in the above formula.

RETURN ON EQUITY

Return on Equity (ROE) basically, is the return from a business, as seen from the owners perspective. It shows what percentage of equity (Shareholder's equity or Owner's capital), the net profit is.

So ROE= Net profit/ Average shareholders equity.

Now we use average shareholders equity due to the fact that the shareholders equity can increase (or decrease) through out the course of the running financial year. For calculating average shareholders equity, we find the average of the beginning and ending balance of the shareholders equity account. It will be more clear in the example given to illustrate the idea.

NET PROFIT MARGIN

The net profit margin gives an idea of what percentage of total revenue, the net profit is. The concept will be clearer in the given below example.

ASSET TURN OVER RATIO

This ratio basically gives an idea of  how many times the assets of a company is turned over through the revenue of a business( sales or service).

Asset Turn over ratio = Total Revenue/ Average total assets

We take the average total assets due to the fact that the total assets can increase (or decrease) through out the course of the running financial year. For calculating average total assets, we find the average of the beginning and ending balance of the total assets. It will be more clear in the example given to illustrate the idea.

Now we know that the basic accounting equation is
ASSETS = LIABILITIES + EQUITY

OR      ASSETS= TOTAL INVESTMENT
So the asset turn over ratio can also be seen as how many times the total investment is turned over in order to milk out profits.

Therefore

ASSETS TURN OVER RATIO = TOTAL INVESTMENT TURN OVER RATIO

FINANCIAL LEVARAGE

As you can see, Financial leverage in the du pont formula is given as the ratio of Average total assets and the shareholder's equity,

And we know that the basic accounting equation  is

ASSETS = LIABILITIES + EQUITY

Financial Leverage = Average total Assets/ Equity

= ( LIABILITIES + EQUITY )/ EQUITY

Which means financial leverage gives an idea of how much the business is jacked up with liabilites.
The more the liability, the more the leverage is.

DU PONT ANALYSYS

Let us recap the du pont formula

ROE = NET PROFIT MARGIN X  ASSET TURN OVER RATIO X  FINANCIAL LEVERAGE

Now let us continue with an example to understand how du pont formula is used to analyse the perfomance of a business, from an owners perspective.

John invests 10000 in a bakery and buys raw material, display racks, baking machinery for 8000 and is left with cash of 2000.

For the first year,
the Cost of raw materials = 7500
Other expenses = 2000
and Sales revenue = 10000

From the above we can see that

The net profit margin  = Net profit/ Total Revenue
= (10000-9500)/10000 =5%
ROE = Net profit/Equity
= (10000-9500)/10000= 5%

Now in the 5th year of business, John had invested an additional amount of 10000 into the business over the years, he had purchased additional equipment, employed a salesperson, introduced new items, increased the efficiency of baking . He could increase the sales revenue to 20000, but the raw material cost and other expenses also increased to 13500 and 3500 respectively, for the 5th year.

For the 5th year John calculated
The net profit margin  = Net profit/ Total Revenue
= (20000-17000)/20000 =15%
ROE = Net profit/Equity
= (20000-17000)/20000 =15%

As he completed 5 years of business, John learned that he could not increase the ROE beyond 15% while, another bakery in the same area had an ROE of 25%. On studying the methods of the other bakery, John came to know that the sales revenue of the other bakery was 25000, with the same investment of 20000. In order to increase the sales revenue, John tied up with a local supermarket for selling his items.

In the 6th year, raw material costs increased to 16750, and other expenses to 4500. But the sales revenue increased to 25000.

he calculated
The net profit margin  = Net profit/ Net revenue
= (25000-21250)/25000 =15%
ROE = Net profit/Equity
= (25000-21250)/20000 =18.75%

At the end of 6th year,John learned two important lessons

1. He could not increase the net profit margin easily. He knew that the industrial standard for net profit margin is around 15%. He had to find another way to increase the ROE.

2. By increasing the sales revenue with respect to the investment, he could increase the ROE even when the net proft margin remained the same. This lead him to asset turnover ratio. Total revenue/ Total Investment is nothing but the asset turn over ratio as we had seen earlier.

in the 6th year

Asset Turn over ratio = Total revenue/ Avg Total Assets
= Total revenue/ Total Investment
= 25000/ 20000 = 1.25
So John understood that by turning over the assets which is equal to the total investment, by 1.25 times in the 6th year, he could increase the ROE to 18.75%.

Now John knew that he cannot increase the net profit margin farther than 15%, without compromising on the quality of raw materials or the methods of preparation or by reducing any other costs as he was already running a lean business. So he has to revert back to the method of further increasing the turnover ratio by increasing the sales revenue. The only way to do that was to go for home delivery. But for that, he would need to buy a delivery van. And a delivery van would require an investment of another 10000. But he could only put up that amount by taking a loan. So in the 7th year, John went for a loan of 10000, with an interest expense of 1000 per annum.

This increased the sales revenue to 40000, with a commensurate increase in raw materials to 25000 and other expense to 9000 and interest expense of 1000.

he calculated for the 7th year

The net profit margin  = Net profit/ Total revenue
= (40000-35000)/40000 =12.5%
ROE = Net profit/Equity
= (40000-35000)/20000 = 25%
Asset Turn over ratio = Total revenue/ Avg Total Assets
= Total revenue/ Total Investment
= 40000/ 30000 = 1.33

Leverage Ratio  = Avg total Assets/ Equity
= Total Investment/ Equity
= 30000/20000 = 1.5

DUPONT Analysis

ROE = Net profit Margin X Turn over ratio X Leverage
= 12.5 X 1.33 X 1.5
= 25

So from 7 years of John's bakery business, we can learn the following

1. ROE will be equal to Net Profit Margin, if a business could turn the investment only one time, ie the turn over ratio=1, and if there is no leverage.

2. Even if there is no leverage, the ROE can be increased by turning over, the total investment, more than one time with the same profit margin.

3. Leverage is the most tricky one here. First of all, all loans have interest, and this additional expense will bear on the profit margin.

Secondly, the leverage increases the total investment, which would decrease the turn over ratio, if the sales revenue does not increase, commensurately. In other words, if the additional fund brought in by taking a loan is put idle, the sale revenue won't increase, on the top of it, the Total Revenur/assets will decrease, which will bring down the turn over ratio. The leverage multiplier won't be enough to jack up the ROE. This will be more clear in John's example.

In the 7th year John had brought in additional 10000 from a loan.

The Leverage = Total investment/ Equity
= 30000/20000
=1.5

Imagine if John went crazy and put all the 10000 loan fund in a safe deposit box, keeping it idle. He would not be able to purchase the delivery van. The sales revenue would remain same as that of the 6th year at 25000. The Raw material costs would be same as 16750, and other expense 4500. On top of it he would have to incur an interest expense of 1000.

The Net profit Margin = Net Profit/Total Revenue
= (25000-22250)/25000
= 11%
The ROE  = Net Profit/Equity
= (25000-22250)/20000
= 13.75%
Had he not taken the loan the ROE would be 18.75%

In order to see what really went wrong, we need to see the du pont analysis

The Turn over ratio  = Total Revenue/ Avg Total assets
= Total Revenue/ Total investment
= 25000/ 30000
= 0.83
Dupont Analysis

The ROE  = Net Profit Margin X Turn Over Ration X Leverage
= 11 X 0.83 X 1.5
= 13.75%

So what we learn from all this is that even though the company is leveraged, it may not produce decent ROE, if the fund from the leverage loan, is not utilized efficiently.

CONCLUSION

Du Pont analysis gives precious insight to the efficiency of  capital management and operational performance of a business, from an investor/ owners perspective. It allows us, not only to compare how leverage is used to enhance the profit of a company, but also to individually compare the net profit margin and the turn over ratio with other competitors in the industry. It allows us to judge if the capital structure justifies, the operational requirement of funds in a business.

## Wednesday, 11 January 2017

### ESOP Accounting Case study of Dabur Limited

Please see the post titled Warrants and Employee Stock Options to understand the basic concepts

Note that I have changed certain notations used in my previous post on warrants and employee stock options, in order to conform to those used in the Consolidated Financial Statements of Dabur Limited. For this case study, I have used the statements for 2011-12

Terms changed

1. Paid in Capital in Excess of Par          to Share Premium
2. Common Stock                                  to Total Shares Issued for ESOP
3. Paid in Capital-ESOP                         to ESOP Scheme Outstanding

I don't need to emphasize the need for ESOP schemes in a growing company. But as we will see, ESOPs incur a cost on the company, specifically on it's shareholders. The following is disclosed in the 2011-12 report of the company.

1. Number of Options granted                    : 1557412
2. Pricing formula : Each option carries the right to the holder to apply for one equity share of the           Company at par/discount to market value.
3. Options vested                                      : 1377056
4. Options exercised                                  : 1377056
5. Total number of shares arising as a result of exercise of option
: 1377056
6. Options lapsed/cancelled                         : 1520376
7. Variation in terms of options                   : None
8. Money realized by exercise of options      : Rs. 672721/-
9. Total number of options in force              : 18287210

The fair value of the options under intrinsic value method is 111.90 as mentioned in the AR. Fair value under this method is the difference between the exercise price and the market price of the share at that time. We can also use the Black scholes Model for evaluating the options.

The formula used for recording the cost of the options based on the intrinsic value method  in the balance sheet is as follows

The maximum of

1.  (Fair value of options   MINUS  a percentage of market price of the shares) x no of options granted.
2.  (Fairvalue of options X no of options granted) MINUS (a percentage of total empoyee compensation for that year)
3. Zero.

So when the options are granted, they are recorded using the above formula, as per indian accounting standards. From the balance sheet, we can find that the options granted in the year 2011-12, is recorded at a cost of 928 lacs. And we can find that the cancelled options is recorded at a total of 802 lacs.

Options are a liability to the company. But they are also long term liabilities. The opposite entry will naturally be a capitalised expense, which will be amortized over the life of the options.

The following is the journal entry for granting options

Deferred  ESOP Scheme Outstanding expense           928
ESOP Scheme Outstanding liability                                                   928

As you can see, the expense for the liability is deferred, which makes it a capitalized asset. This asset can be found under non current assets in the balance sheet. The entry for cancelled options is as follows.

Deferred  ESOP Scheme Outstanding expense                                    802
ESOP Scheme Outstanding liability                          802

This capitalised asset, needs to be amortized over the life of the options. The balance in the Deferred  ESOP Scheme Outstanding expense  account at the beginning  is Rs 8295 lacs. the amortization entry is as follows.

Amortization Expense                                              3037
Deferred  ESOP Scheme Outstanding expense                                    3037

The balance in the ESOP Scheme Outstanding liability account is Rs 11681 lacs at the beginning. This was accumulated over time, This liability gets reduced only when the options gets exercised.

The total no of options exercised is 1377056. An equivalent amount of share is issued in leu of the options exercised ie 1377056. The value of the options exercised is 1219 lacs, which is calculated using the formula mentioned above that conforms to Indian Accounting standards. The weighted average exercise price (per option) is Rs 50.90. So the company should receive a cash of
1377056 X 50.90 = 700.9 lacs from the employees for exercising the options. But it has received only
Rs 672721/- in total, which is only Rs 0.48/- per options. I don't know the terms and conditions of ESOP scheme at Dabur Limited, but this seems an excess amount of compensation to the employees, especially to the promoters, who are also directors on the board.

For the year 2011-12, the average price of shares was Rs 100/-. The total benefit for the employees under ESOP scheme = (100 X 1377056)-672721=13.7 crore. This is in additional to all other salaries and remunerations.

The journal entry for options exercise is as follows

Cash                                                                        7
PL Account                                                              7
ESOP Scheme Outstanding liability                           1219
Total Shares issued for ESOP                                                                14

For the company there was also a transition adjustment of 79 lacs in the ESOP Scheme Outstanding liability account. This is a one time compliance adjustment and can be ignored.

The summary of the ESOP Scheme Outstanding Liability account is as follows
 ESOP Scheme Outstanding Previous Year Balance 11681 Addition during this year 928 Allotted during this year -1219 Cancellation during this  year -802
 Transition Adjustment -79 End of Year Balance 10509

The Summary of Deferred  ESOP Scheme Outstanding expense account is as follows

ESOP Scheme Outstanding expense account

 Previous Year Balance 8295 Addition during the year 928 Less : Cancelled during the year -802 Less: Amortised during the year -3037 End of Year Balance 5384

The issue of 14 lac shares is financed partly from PL account and partly with cash received from employees. The irony is that even the par value of Rs 1 per share is not paid for by the employees and had to be partly financed from PL Account.

The liability of ESOP Scheme Outstanding is reduced by 1219 lac and the shareholder's equity of share premium is increased by the same amount. This equity is created from charging the profit of the company regularly through amortization. This is equivalent to siphoning retained profits (surplus) to create the liability first, and then the equity, as the options are exercised.