DuPont Financial Analysis Model : A Process For Knowing Where to Spend My Management Time Tomorrow Morning After Breakfast
By
Kevin Bernhardt, UW-Extension, UW-Platteville, and
UW Center for Dairy Profitability
Our
computer technology today provides wonderful opportunities to collect,
manipulate, and process data including financial analysis data. Sure, it gives a manager lots of numbers, but
what do they mean in terms of where to spend my creative management time
tomorrow morning after breakfast?
There
is no lack of ratios to calculate from financial data, each of which is a
valuable piece of information to the manager.
The Farm Financial Standard Council’s sweet 16 ratios (recently
expanded) have been a standard for years in helping farm managers evaluate
their financials. However over several
years of teaching undergraduate students and Extension clientele I often found
it difficult for people to wrap their arms around what the ratios were
indicating and ultimately where to spend their valuable management time. The challenge often led to indifference by
the undergraduate students and a lack of seeing any value to go further by
Extension clientele.
The DuPont system for
financial analysis is a means to fairly quickly and easily assess where the business
strengths and weaknesses potentially lie and thus where management time may
optimally be spent. It is not the only
nor the most thorough, but it is a fairly straight-forward and systematic means
to drill back into the financial numbers to determine the source or lack
thereof for financial performance.
If we are lucky enough to have the
minimum number of financial documents needed to conduct a meaningful financial
analysis (both beginning and ending balance sheets, either an actual accrual or
accrual adjusted income statement, and a statement of cash flows), we are then
inundated with pages and pages of intimidating numbers to sort through.
This gives many managers and advisers a
justification not to give their financial records anything more than a passing
glance. This is unfortunate. A good financial performance analysis should do
more than inform about how a farm performed in the past. More important, it
should provide the manager and adviser with insight regarding how to prioritize
activities that will enable the farm to improve its financial performance.
The DuPont system has
disadvantages as does any financial analysis system. However, its advantage beyond simplicity of
use is that it takes into account the major levers of firm profitability –
efficiency, asset use, and debt leverage.
Anatomy
of Profits
Before describing the
DuPont system, consider the anatomy of profits.
The accounting equation is:
Total Assets = Total Debt + Total Owner Equity
As the accounting
equation shows every penny of assets comes from one of two sources – that
financed by debt (borrowed capital) and that financed by equity (the owner’s
own money). Assets can also be described
by those that are capital assets versus short-term inventory or market
assets. Capital assets are longer-term
investments (land, machinery, breeding stock, etc.) that are not sold
themselves to make profits, but are put to work to produce marketable inventory
that can be sold for profits (feeder cattle, eggs, etc.). Inventory also includes inputs such as feed,
seed, and fertilizer.
Businesses earn
profits by mixing their labor and management with inputs and capital assets to
produce goods for sale. The DuPont
system recognizes this recipe for profit-making and segregates it into three
distinct components or levers:
1. Earnings (or efficiency),
2. Turnings (effective use of
assets), and
3. Leverage (using debt to
multiply earnings and equity)
In the DuPont system
one can drill back into these three levers to determine where profit
performance is coming from and potentially determine where management time
should be spent for improving profits.
Specifically DuPont measures:
1. How efficiently inputs are being used to generate profits [Earnings]
2. How well capital assets are being used to generate gross revenues
[Turnings]
3. How well the business is leveraging its debt capital [Leverage]
Figure 1 shows a
graphic of the DuPont system. It begins
on the far right side with Rate of Return on Equity (ROROE). High ROROE is the prize in the DuPont system. ROROE is calculated as:
Net Income from Operations – Unpaid Labor
& Management
Total Owner Equity
The financial manager
can then drill backward to see where ROROE performance either is, or is not,
coming from.
Starting on the upper side ROROE, in-part,
comes from how well the business is earning profits from its assets as measured
by the Rate of Return on Assets (ROROA).
ROROA is calculated as:
[Net
Income from Operations + Interest
–
Unpaid Labor and Management
Total Assets
It makes sense that the higher the ROROA the
higher the ROROE. In-turn, the ROROA comes
from two components or levers of profitability.
One is how efficient the manager is in
turning inputs into outputs, or in a financial sense, how efficient the manager
is in turning the gross revenue of dollars coming into the business into net
profits that are kept in the business after all expenses are paid. This is the “Earnings” lever and is measured
by the Operating Profit Margin Ratio (OPMR).
The calculation is:
[Net
Income from Operations + Interest
–
Unpaid Labor and Management
Gross Revenue
Interest is added back so that the measure
you get is one that measures efficiency of operations regardless of the debt
structure. Debt structure effects will
come into the system later. In
situations where there is unpaid labor and management it is deducted to
recognize the value of the labor and management. The more efficient you are in turning gross
sales into profits that you keep the higher your Rate of Return on Assets and
ultimately the higher your Rate of Return on Equity.
The second source of ROROE is how well you
are using the assets of the business.
This lever is referred to as “Turnings” meaning how well you are turning
assets into production and sales of product.
To use an extreme example, if you had a 300 acre farm (all tillable)
that you left sit idle then your performance of turning assets into production
and sales of product would go way down.
The “turnings” lever is measured by the Asset Turnover Ratio (ATO). The calculation is:
Gross
Revenue
Total Assets
The better able you are to use the assets you
have to produce and sell product the higher the Rate of Return on Assets will
be and the higher the Rate of Return on Equity.
The last lever is “Leverage,” which is also
known as “Equity Multiplier”. Before
going further with the explanation of leverage, it is worth backing up a step
and exploring the accounting equation again
(Total Assets = Total
Debt + Total Equity).
Given this equation, which is true for every
business, then any profitable return to the use of assets is a profit return to
the assets financed by debt and to those financed by equity. Equity is fairly straight-forward, if you
invest $100 of your own money and earn $10 back then your equity has returned
10% (10/100). For the return to debt it
is a bit more complicated because you have to pay someone for the use of the
debt – interest. So, the question
becomes whether or not the debt you have is returning a profit larger than the
interest you have to pay for using that debt.
If it is then the leftover profit after paying interest is an additional
return to your equity. That is, if I’m
paying 8% interest and my profit return on the debt is 10%, then I not only can
pay my interest, but I have 2% leftover that I get to keep. This 2% becomes and increase to my equity. This is why the debt or leverage component of
DuPont is sometimes called an “Equity Multiplier.”
It may seem an odd statement to make for
some, but if you want to increase your ROROE then one way to do it is to
increase your debt! The trick is that the
debt must be managed in a way that returns a profit greater than the interest
rate. If it is not then the equity
multiplier still works, just in the wrong direction!
Ultimately the leverage lever is measured by
the Debt to Asset ratio (D:A), which is calculated as:
Total
Debt
Total Assets
For ease of the math in the model, the
leverage lever can be expressed as:
Total
Assets
Total Equity
The greater this ratio then the more the
proportion of debt is in the mix of assets.
If the assets financed by debt are earning a return greater than the
interest rate, then the higher the ratio the greater the Rate of Return on
Equity.
Figure 2 shows the same DuPont model with the
ratio measures.
Note, the interest
rate adjustment in the ROROA box is the adjustment needed to return the cost of
interest before measuring the Rate of Return on Equity. Recall that interest was taken out when
calculating the OPMR.
The DuPont system as
illustrated allows you to identify where profit performance is, or is not,
coming from in one or more of three areas.
Once identified then the next step is to drill back into the numbers
that make up the ratio of concern.
For example, if the
OPMR is found to be lower than the manager would like it to be then look at the
numerator of the OPMR (net income from operations + interest – unpaid labor
& mgt) to determine what might be the problem, particularly expenses. Compared to your more profitable peers what
are your labor, vet, repair, and other input costs?
If the performance
problem appears to be coming from a low ATO then the manager might drill back
into the business assets to see how well they are being used. Are there dead assets in the business (ones
not being used to create product for sales), does the business have excess
machinery capacity, or are there assets that are under productive (poor weight
gain, breeding cycles too long, sickness, death loss, etc.).
If the debt structure
is low, that is debt is not leveraging equity as much as peer businesses, then
the manager might drill back and question how debt is being used. Could additional debt be used to improve
facilities, machinery, etc. that ultimately pays for itself in higher
production and sales or does debt that is not productive need to be paid off
(or perhaps the assets sold).
As with all financial
analysis systems the model is only as good as the numbers that go into it, that
is, garbage in then garbage out. Another
valuable piece of information to have to evaluate DuPont is benchmarks of
profitable peers. There are general
ranges for each of the ratios, but each industry and your size within an
industry makes a difference as to what is “good” for the ratios. Finally whether you rent or own the assets
you use in a business also makes a difference in the interpretation of the
ratios.
Appendix A provides a
brief example of using the DuPont model.
It is often said that
management is part science and part art.
The DuPont system has both elements.
The ratio calculations are science and just a manipulation of
numbers. The art is interpreting the
ratios and drilling back into where the ratios indicate there could be
challenges and thus information of where to spend your creative management time
tomorrow morning after breakfast.
Appendix A
Brief
Example (Adapted from an example from Texas Tech University) http://www.aaec.ttu.edu/faculty/phijohns/AAEC%204316/Lecture/notes/DUPONT.htm
Table
1. DuPont Analysis for Two Farms
|
Farmer
A
|
Farmer
B
|
1.
Operating profit margin ratio (OPMR)
|
0.30
|
0.12
|
2.
Asset turnover ratio (ATO)
|
0.20
|
0.36
|
3.
ROROA (1*2)
|
0.060
|
0.043
|
4.
Interest expense to avg. farm assets
|
0.05
|
0.03
|
5.
Equity multiplier
|
2.00
|
1.50
|
6.
ROROE (3-4) * 5
|
0.02
|
0.02
|
Farmer
A and Farmer B each have a 2 % ROROE. However, the levers of the DuPont system indicate
that the sources of the weakness are different. Farmer A has a stronger operating profit
margin ratio but lower asset turnover compared to Farmer B. Furthermore, Farmer
A has a higher leverage ratio (equity multiplier) than Farmer B.
The
weak ratios for each farm may be decomposed into components to determine the
potential sources of the weakness. To improve asset turnover Farmer A needs to
increase production efficiency or price levels or reduce current or noncurrent
assets. To improve profit margins, Farmer B needs to increase production
efficiency or price levels more than costs or reduce costs more than revenue.
The
DuPont analysis is an excellent method to determine the strengths and
weaknesses of a farm. A low or declining ROROE is a signal that there may be a
weakness. However, using the DuPont analysis can better determine the source of
weakness. Asset management, expense control, production efficiency or marketing
could be potential sources of weakness within the farm. Expressing the
individual components rather than interpreting ROROE itself may identify these
weaknesses more readily.
