Dupont analysis: Understanding Critical Financial Ratios

History of DuPont analysis:

In the early 1900s, the management of the DuPont company, which was running the first conglomerate, developed the most famous and useful financial ratios. Not only did management have to rethink the way the organization was structured, but it also had to find a way to measure the performance of businesses with a variety of operating characteristics. For example, some divisions had a large amount of fixed assets, others had few.

DuPont Analysis

FINANCIAL MANAGEMENT: DuPont’s solution was to create a set of numerical tools that provide quick insight into a company’s financial characteristics and performance, once the basic sales situation and life-cycle phase have been identified. The core set of ratios was designed to measure the central functions of the business – marketing, operations, and finance – as well as its general performance. Because of their use as a basic financial framework, the summary DuPont ratios will be briefly introduced here. In using these ratios to judge performance, however, it is critical to make the comparison with companies in similar businesses.

DuPont Ratio Analysis

1. Operating Efficiency:

(Sales / Assets)

The volume of sales a dollar of assets can generate shows the asset intensity of a business. An electric power company may generate only 20 cents of sales per dollar of assets. A retail chain may generate several dollars in sales for each dollar of assets. The more sales per dollar of assets, the more efficiently the business is being run.

2. Marketing Efficiency:

(Profits / Sales)

The profit margin suggests how well the marketing function can position the product and deliver it to the consumer. The ratio is also indicative of the intensity of competition, as greater competition pushes prices down and lowers the profit-to-sales ratio.

3. Return on Assets:

(Profits / Assets)

This ratio shows the efficiency with which assets are being used. It is the product of the first two ratios: the sales component cancels, leaving profit and assets. The relationship shows why the first two ratios are usually inversely related. To generate sufficient profitability to attract capital, a business with a low profit margin must do a high sales volume on the capital invested. A business with a low volume of sales on assets must have high profits on the sales it does make. A high profit on assets, however, attracts competition and new entrants; a low profit on assets drives out marginal players. The profit margins of an asset-intensive business are protected, to a degree, by the high cost of entry. The asset-light business has no such protection. Its margins will erode quickly without assets such as protected intellectual property.

WATCH THIS: You should carefully consider the characteristics of your firm’s business to make sure these relationships are understood. Attempting to position your business against what the ratios suggest is the way that industry works can present serious problems.

These first three ratios provide insight into marketing and production, but not into the financial dimension. Less risky businesses should operate with less equity; businesses with higher risks usually require more equity. A key financial task is to balance the debt and equity of the capital structure to provide a return to the equity investor that is suitable for the risk involved. If the returns are too low, investors will withhold or withdraw funds. The wise entrepreneur knows when it is efficient to redeploy assets. The gross measure of financial structure is the next ratio.

4. Financial Efficiency:

(Assets / Equity)

This ratio (also called financial leverage) measures the quantity of assets a dollar of equity can command. In a safe business, such as banking, a dollar of equity can support 12 dollars of assets. In a highly risky business in a startup phase, equity might command less than two dollars of assets.

The return on equity (ROE) is the product of Ratios 3 and 4, return on assets and financial efficiency. When Ratios 3 and 4 are multiplied, the asset term drops out, leaving the return on equity.

5. Return on Equity:

(Profits / Equity)

This ratio measures equity’s efficiency. The return on equity is arguably a better measure of capital attraction than the return on assets, assuming a capital structure that enhances value rather than destroying it with excessive risk. ROE can show the positive effect of appropriate leverage. Return on assets may appear low when debt can be efficiently used in comparison with cases when a high proportion of equity is required.

Analysts expect much less variation in the ROE than in other components of the DuPont analysis. The ROE ratio, therefore, can be used to make comparisons across types of companies because the special characteristics of each type should be “washed out” of the ratio analysis. If the ROE is low,you should contract the business or perhaps sell it to someone who can better use its assets. This extracts your capital so it can be redeployed in higher ROE investments.

Making a DuPont analysis:

The five basic DuPont analysis can be elaborated depending on the analytical depth required. Ratios 1, 2, and 4 have many components, such as the turnover of accounts receivable and inventories, the ratios of cost of goods sold and other components of the income statement to sales, the days of purchases outstanding, and the long-term debt-to-equity ratios. A review of the initial set of five ratios, however, and of their trends over time, will identify those ratios for which further analysis is likely to be a productive activity.

Two major problems in Dupont analysis are the variations in accounting among companies and between the income statement and the balance sheet for a given firm. The use of last-in – first-out (LIFO) inventory accounting, for instance, creates serious distortions in all ratios for which the inventory is a component. Although this technique helps provide more realistic income statements in inflationary times, it creates an unrealistically low inventory figure. The asset efficiency of a steel company may therefore look as good as that of a grocery chain, because the steel company has been on LIFO since 1956 and carries its inventory at a fraction of current cost. The return on assets figure is also distorted. These distortions are reduced, however, when calculating the return on equity because the asset component of the fraction cancels.

Calculating sustainable growth rate with DuPont analysis:

The Sustainable Growth Rate (SGR) has again become a popular analytical tool because it shows the sales growth rate that can be sustained without recourse to external equity. Internally generated funds include retained earnings supported by spontaneously created liabilities, such as accounts payable and short-term debt, and by the target proportion of long-term debt, an external source.

A precise computation of the SGR is complex, but a reasonable approximation can quickly be derived by calculating the rate of increase in the equity account from newly retained earnings, that is, earnings retained in a year divided by total equity at the beginning of the year. If the DuPont ratios have been calculated, this ratio is the ROE (Ratio 5) multiplied by the proportion of the earnings not being paid out as dividends. For many smaller enterprises, which do not pay dividends, the SGR is the same as the ROE.

6. Sustainable Rate of Growth:

(Return on Equity = (Profits — Dividends) / Profits)

This ratio, like any other calculation of the sustainable growth rate, must be carefully interpreted to allow for volatile returns. Another complication occurs when a company decides to use excess debt capacity or has too much debt and wishes to reduce it. In the first instance, the SGR is temporarily higher than the calculation would indicate. For the moment, debt can be added in greater than the optimal proportion as provided by Ratio 4. In the second instance, growth is temporarily hampered because internally generated funds must be devoted to reducing the company’s debt rather than to investing in new assets. In this case, new equity may be needed to lessen the problem.

The logic behind Ratio 6 as an estimate of the SGR relies on the relatively stable relationships in Ratios 1, 2, and 4 that exist for most businesses. Given a stable relationship between assets and equity (and without spare or excess debt), assets can grow no faster than equity.

In a mature or declining business, sales often grow at a slower rate than equity. This condition permits retirement of debt, payment of higher dividends, and perhaps repurchase of shares to keep the proper relationship between debt and equity.

WATCH THIS: A greater challenge occurs when sales are growing faster than equity. Because management, and particularly owners of smaller enterprises, avoid issuing equity, the leverage ratio (Ratio 4, asset to equity) is allowed to move upward. The locomotive of sales pulls the train of assets along faster than the equity and proportional debt can provide the sources needed to fuel the speed of expansion. To keep the train from slowing, debt is added to the fuel mix in a higher proportion than the target. The solution can only be temporary. If it continues, the capital markets will shortly force the company to raise new external equity. For a smaller enterprise, this occurs when the bank or the trade refuses to provide additional credit until the company adds more equity.

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