DuPont Financial Analysis Model

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.

A colleague, Gregg Hadley (UW-River Falls), summed up well the DuPont system in a recent article on E-Extension (The DuPont Analysis: Making Benchmarking Easier and More Meaningful, Updated June 10, 2009, http://www.extension.org/pages/The_DuPont_Analysis:_Making_Benchmarking_Easier_and_More_Meaningful):

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.

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Eight Ways to Cut Business Energy Costs

Here are some proven ways to reduce energy use at your company that not only save money but help preserve the environment as well:

1. Conduct an energy audit: This will help you identify and prioritize the best energy-saving opportunities for your business. Local utility companies may provide this service at no cost. Otherwise find a company that specializes in conducting energy audits for a fee.
2. Establish benchmarks: Once you evaluate your current energy use through an audit, establish goals for cutting costs and monitor them. Several online tools can help, including Portfolio Manager from the U.S. Environmental Protection Agency’s Energy Star program.
3. Shut down at night: Leaving equipment, computers, and lights turned on overnight uses more energy than you think, not only from the equipment itself but also from the heat it emits, which raises air conditioning costs.
4. Change lights simultaneously: Light bulbs start operating inefficiently once they reach 80 percent of their rated life. So instead of changing bulbs one at a time when they burn out, change all of the bulbs in your office at the same time on a uniform schedule. Replacing fluorescent lights with T8 tubes and upgrading to electric ballasts can reduce your electrical load by up to 40 percent.
5. Keep the sun out: Unshaded windows are a huge energy waster. Fixing this problem is as easy as installing window shades, blinds, or curtains or tinting windows with film that’s designed to keep the heat out and the cool in.
6. Retrofit your heating, ventilation, and air conditioning system: Newer, more energy-efficient heating, ventilating, and air conditioning systems can reduce a building’s overall energy consumption by as much as 40 percent. You can receive a federal tax credit equal to 30 percent of the cost (up to $1,500) of a new HVAC system if it is purchased and installed before December 31, 2010. A number of other energy-efficiency upgrades also qualify for this credit, including new windows, doors, insulation, roofs, and renewable energy systems.
7. Install a cool roof or solar panels: Using highly reflective materials, a cool roof can drastically lower surface temperatures, which can significantly reduce the workload of your HVAC system. Perform your own cost-benefit analysis to determine the potential breakeven point and whether the upfront expense is feasible for your company. Solar panels may also require a large upfront expense and a potentially long-term breakeven point. However, you may be able to cushion this by “renting to own” the panels. These programs allow businesses to pay no upfront or maintenance costs but purchase their electricity from the panel provider, often at a discounted rate.
8. Start a telecommuting program: Telecommuting has become more common in recent years as more companies recognize that employees don’t have to be onsite to do their jobs. With fewer employees present in your building, your company will use less energy. You’ll also be doing your part to reduce carbon emissions by lowering the number of commuters on the road.

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THE GROWTH CORRIDOR: FINANCIAL THRESHOLDS TO OPTIMUM FIRM EXPANSION

Abstract: One of the most controversial issues in the growth literature is whether there is an optimal growth rate that maximizes firm performance. Contrary to prior research, we argue that optimum growth rates are firm-specific and, as such, cannot be established across whole populations of firms. Drawing on financial theories, we develop a model of optimum firm growth. Our research suggests that there are firm-specific corridors of optimum growth and that  they  may  have  a  significant  effect  on  firms'  long  term-performance.  Our  research  shows  that  a  company’s minimum  growth  requirement  results  from  shareholder’s  earnings  expectations  and  that  the  upper  boundary  of growth is defined by the firm’s sustainable growth rate.

THEORY DEVELOPMENT AND HYPOTHESES

Introduction

Managerial practice as well as academic research has linked firm growth to various benefits. Growth is regarded

as essential if companies are to remain vital and competitive (Drucker, 1973; Robins & Wiersema, 1995). At the same time, firm growth has been related to increasing complexity and various managerial problems. Studies have shown  that  excessive  growth  can  destroy  shareholder  value  and  adversely  affects  profitability  (Baumol,  1962;

Hedberg,  Nystrom,  &  Starbuck,  1976;  Richardson,  1964;  Whetten,  1987).  There  is,  nevertheless,  inconclusive

empirical  evidence  regarding  the  relationship  between  growth  and  performance.  While  some  studies  have  found support for a curvilinear relationship (e.g. Ramezani, Soenen, & Jung, 2002), others revealed a positive and linear effect (e.g. Miedich & Melicher, 1985), or no significant linkage at all (e.g. Markman & Gartner 2002). From these inconsistencies, the questions arise as to whether there is an optimum pace of growth, and if so, how this optimum rate can be determined.

Growth and Firm Performance

The most relevant explanation for previous inconclusive findings may be traced back to the practice of classifying growth  rates  across  companies  and  industries  into  normal,  high,  and  hyper  growth  (e.g.  Markman  and  Gartner, 2002). However, various researchers have argued that firms’ ability to growth is contingent on their unique resource base and market conditions (i.e., Penrose, 1959; Porter, 1980; Slater, 1980). It is thus more likely that the relative  degree of growth is contingent upon firm-specific characteristics, rather than being valid and applicable to firms in general. Consequently, we assume that the level of optimum growth varies from company to company and cannot be established across whole populations of firms.

Determinants of Firm Growth

Researchers  in  the  field  of  management  generally  accept  that  a  firm's  resource  endowment  is  one  of  the  main determinants of its ability to grow (Mishina, Pollock, & Porac, 2004). Two broad types of resource categories have been  discussed:  financial  and  human  resources  (e.g.  Bamford  et  al,  1999;  Cooper  et  al.,  1994).  Studies  from the finance literature emphasize the role played by financial resources in enabling and curtailing growth (Clark et al, 1989; Higgins, 1977; Kyd, 1981).

Financial growth requirements. From a financial market perspective, firms’ growth requirements are determined by the shareholders’ long-term earnings growth expectations, which are inherent in the firm’s current market value Koller et al, 2005: 74). Empirical findings suggest that there is a reward for meeting or beating expectations and a penalty for failing to do so (Kasznik & McNichols, 2002; Skinner & Sloan, 2002). While the premium is relatively small  in  the  short  term,  there  is  a  significantly  greater  return  for  firms  that  consistently  meet  expectations  over several years (Kasznik & McNichols, 2002). A firm's minimum growth requirement may thus be determined by the rate of expected sales growth (ESG): the annual percentage increase in sales required (after considering the firm’s growth with regard to its net income) to meet market expectations. Growth consistently below ESG will negatively affect firm returns.

Hypothesis 1: Firms that achieve long-term sales growth greater than their rate of expected sales growth outperform firms growing below this rate.

Financial  growth  limits.  Over  the  years,  the  finance  literature  has  presented  numerous  models  with  which  to measure the growth that a firm, given its operating and financial constraints, can sustain (i.e., Babcock, 1970; Clark et al, 1989; Higgins, 1977, 1981; Kyd, 1981; Varadarajan, 1983). Sustainable growth refers to the “maximum annual increase in sales that can be achieved based on target operating, debt, and dividend payout ratios” (Van Horne, 1997: 743). If a firm grows at a faster rate than its sustainable growth rate (SGR), it will be forced to increase its debt ratio, decrease dividends, or issue new equity. Research has shown that all three options are limited, usually to the detriment of financial soundness. Excessive growth, defined as growth above the firm’s financial means, is thus regarded as a main reason for insolvencies (Probst & Raisch, 2005). While growth above the SGR may be detrimental, sales growth that remains below the SGR allows the firm to increase its dividends, reduce its leverage, and build liquid assets (Higgins, 1977; Varadarajan, 1983).

Hypothesis 2: Firms that restrict their long-term sales growth to the limits set by their sustainable growth rate outperform firms growing above this rate.

The optimum growth corridor. Research has also indicated that firms’ expected sales growth (ESG) and sustain- able growth (SGR) rates are closely interrelated. Studies from behavioural finance suggest that market overreaction and underreaction may lead to irrational price deviations (Abarbanell & Bernard, 1992; De Bondt & Thaler, 1985).

If the SGR slips below the ESG, firms have to choose between two suboptimal growth strategies: First, the firm may limit its actual growth to the SGR, which is likely to disappoint shareholders and to cause declining stock prices (i.e., Kasznik & McNichols, 2002). Secondly, the firm may continue to grow above its ESG, preserving its short- term valuation  at  the  cost of increasing  its  long-term risk.  Both growth  strategies  are  thus  likely  to  contribute  to declining market performance. Firms are clearly better off when the SGR exceeds the ESG, providing the potential

for sustainable growth at or above the shareholders’ expectations.

Hypothesis 3: Firms with a long-term SGR above the ESG outperform firms that lack this corridor of growth.

If there is a growth corridor, firms should pursue sales growth above the ESG, but within the limits set by the SGR. As discussed above, growth below the ESG has been related to declining return to shareholders, while growth above the SGR has been linked to increasing debt and the risk of bankruptcy.

Hypothesis 4: Long-term sales growth exceeding the ESG but remaining within the limits set by the SGR, is linked to superior performance.

RESULTS

To test our hypothesis, we employed a quantitative empirical research design. We drew our sample from the firms listed in the Fortune 500 index for 2005. Our reference timeframe comprises the ten years between 1995 and 2004.

Analysis.  To  test  our  first  three  hypotheses,  we  examined  the  difference  in  the  mean  of  the  total  return  to shareholders with regard to firms growing above and below ESG and SGR as well as the mean of those company's whose SGR exceeds ESG and those that lack this corridor of growth. To test the fourth hypothesis, we compared the differences in the mean of firms whose sales growth exceeds the ESG, but remains within the limits set by the SGR with that of firms that fail to meet these conditions.

Results. Our results clearly indicated that the long-term performance of firms growing above ESG is significantly higher than the performance of those firms that grow below ESG. By testing hypothesis 2, we verified that firms growing above the SGR yield significantly lower long-term performance than firms growing below the SGR. The results for Hypothesis 3 showed that the first group’s performance is significantly higher than that of the second group. Finally, we found a significant difference in the long-term performance of firms growing within the corridor of sustainable growth and those who don't. In sum, our preliminary results provide support for all four hypotheses.

CONCLUSION

Besides having provided a tool for managerial practice, the findings of this study have important implications for corporate growth and organizational change theories. Prior research on corporate growth has mainly focused on the directions and modes of corporate growth. In this study, we suggest a third dimension: the pace of growth. Prior research has largely neglected this aspect of firms’ growth strategies. However, some recent studies have indicated that  pace  may  indeed  matter,  and  found  pace  to  be  an  important  moderator  of  the  relationship  between  growth directions or modes and performance (e.g. Chang, 1995; Hayward, 2002; Pettus, 2001; Vermeulen and Barkema,

2002; Wagner, 2004). In a more general context, our study contributes to recent studies on the pace of organizational change. Traditionally, such studies support fast change as being beneficial in overcoming unproductive inertia in firms’ mental maps and routines (Barkema & Vermeulen, 1998). Firms that develop too slowly are expected to fall behind as their rivals race ahead. However, since a firm’s capacity to expand and absorb new experiences is limited,

the pace of change may also become too high (Cohen & Levinthal, 1990; Perlow, Okhuyson, & Repenning, 2002). Our study contributes to this research by providing concrete limits to firm expansion’s optimum pace.

By Flora Ferlic,The Growth Corridor: Financial Thresholds To Optimum Firm Growth  ,at

http://sandiego.strategicmanagement.net/handouts/b5dac82f70ef0cd0008dfb93b81fe07fThe%20Growth%20Corridor%20Handout.pdf

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