## 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.