dupont system macfarlane

DuPont System For Financial

AnalysisBy Kevin Bernhardt, UW-Platteville and UW-

ExtensionMarch 10, 2010

http://cdp.wisc.edu/Management.htm

First,This Thing Called Debt

Anatomy of Returns

Total Assets = Total Liabilities + Total Equity

Total amount of stuff used in the business to make profits (supplies, inputs breeding stock,

machinery, etc.)

How much of that stuff is

financed by the “bank”, that is,

debt capital.

How much of that stuff is financed by

your own money, that is, equity capital.

So, when you make profits, those profits are a return to all the assets, some of which is a return to your money invested (equity capital) and some of which is a return

to the bank’s money (debt capital).

Anatomy of Returns – Case 1

$1,000 of Total Assets (all financed by my own money) generated $500 of total revenue, $400

of total expenses, and thus $100 of profits.

1001000

=

$10 cents of income per dollar

of asset

ROROA = 10%

Since it is all my money, then ROROE = 10%

Anatomy of Returns – Case 2$1,000 of Total Assets (financed $700 by my own money and $300 @8% borrowed from a bank) generated $500 of total revenue, $400 of expenses before interest for $100 profit,

and $76 profits after interest expenses.

$700

76700

=

$300

My money(Equity Capital)

Bank’s money(Debt capital)

1001000

=$10.9 cents of income

per dollar of your money

Before interest $.10 cents of income per dollar of all

assets used.Total Assets $1000

ROROA = 10%

ROROE = 10.9%

ROROA>i-rate The extra is payment to equity 10% 8% Thus 2% additional to Equity

I leveraged someone else’s money to increase the return to my money.

Anatomy of Returns – Case 2$1,000 of Total Assets (financed $700 by my own money and $300 @8% borrowed from a bank) generated $500 of total revenue, $400 of expenses before interest for $100 profit,

and $76 profits after interest expenses.

ROROA>i-rate Thus ROROE>ROROA (that’s good)

Return on equity capital 10% * $700 $70

Return on debt capital (10%-8%) * $300 $6

Total return $76

$76/$700 = 10.9% ROROE

Anatomy of Returns – Case 3$1,000 of Total Assets (financed $700 by my own money and $300 @8% borrowed from a bank) generated $500 of total revenue, $500 of expenses before interest for $0 profit, and

-$24 profits after interest expenses.

$700

-24700

=

$300

My money(Equity Capital)

Bank’s money(Debt capital)

01000

=-$3.4 cents of income

per dollar of your money

Before interest $0 cents of income per dollar of

all assets used.Total Assets $1000

ROROA = 0%

ROROE = -3.4%

Making 0% on all assets, but paying 8%, and the additional 8% is coming out of equity.

Anatomy of Returns – Case 3$1,000 of Total Assets (financed $700 by my own money and $300 @8% borrowed from a bank) generated $500 of total revenue, $500 of expenses before interest for $0 profit, and

-$24 profits after interest expenses.

ROROA<i-rate Thus ROROE<ROROA (Not Good)

Return on equity capital 0% * $700 $0

Return on debt capital (0%-8%) * $300 -$24

Total return -$24

-$24/$700 = -3.4% ROROE

Anatomy of Returns – Case 4$1,000 of Total Assets (financed $700 by my

own money and $300 @15% borrowed from a bank) generated $500 of total revenue, $400 of expenses before interest for $100 profit,

and $55 profits after interest expenses.

$700

55700

=

$300

My money(Equity Capital)

Bank’s money(Debt capital)

1001000

=$7.9 cents of income

per dollar of your money

Before interest $.10 cents of income per dollar of all

assets used.Total Assets $1000

ROROA = 10%

ROROE = 7.9%

Making 10% on all assets, but paying 15% on debt portion (ROROA<i-rate), and the difference must come from equity.

Anatomy of Returns – Case 4$1,000 of Total Assets (financed $700 by my

own money and $300 @15% borrowed from a bank) generated $500 of total revenue, $400 of expenses before interest for $100 profit,

and $55 profits after interest expenses.

ROROA<i-rate Thus ROROE<ROROA (Not Good)

Return on equity capital 10% * $700 $70

Return on debt capital (10%-15%) * 300 -$15

Total return $55

$55/$700 = 7.9% ROROE

So, How Is Money Made?

• Through Three Primary Levers– By being efficient with your operations– By getting the most out of your assets– By leveraging your money

• that is, helping your own money do bigger and better things through borrowed use of someone else’s money.

So, How Can I Analyze How I am Doing At Making Money, Or better yet how I might make

more money?

• By analyzing each of the three levers that leads to Return on Equity – ROROE:– Efficiency of operations– How well assets are working into profits– Leverage

Introducing the DuPont System for Financial Analysis

DuPont System

• Developed in 1919 by a finance executive at E.I. du Pont de Nemours and Co

• “The DuPont system is a way of visualizing the information so that everyone can see it.” (Stephen Jablonsky, Penn State University)

• DuPont analysis “is a good tool for getting people started in understanding how they can have an impact on results” (Doug McCallen, Caterpillar Inc.)

• “Number one, it’s simple” (Sam Siegel, CFO)

DuPont System

• “DuPont Financial Analysis Model is a rather straightforward method for assessing the factors that influence a firm’s financial performance.” (Gunderson, Detre, and Boehlje, AgriMarketing 2005)

DuPont System – What is It?

• The system identifies profitability as being impacted by three different levers:

1. Earnings & efficiency in earnings

2. Ability of your assets to be turned into profits

3. Financial leverage

Earnings

TurningsLeverage

Operating Profit Margin

Asset Turnover

Return On Assets (less interest adj.)

Financial Structure

Return On Equity

X =

X =

IncomeStream

InvestmentStream

Turnings/Asset Use

Leverage

DuPont System

Earnings/Efficiency

Operating Profit Margin

Asset Turnover

Return On Assets (less interest adj.)

Financial Structure

Return On Equity

X =

X =

IncomeStream

InvestmentStream

Earnings

Turnings

Leverage

DuPont System Ratios

OPMR

ROROA

ROROE

ATO

Total Assets/Total Equity

Derived from the Debt To

Asset Ratio (D:A)

Let’s Do The Math

Operating Profit Margin

Asset Turnover

Return On Assets (less interest adj.)

Financial Structure

Return On Equity

X =

X =Turnings/Asset Use

Leverage

DuPont System

Earnings/Efficiency

NFIFO + interest paid - unpaid labor/mgt ROROA = Total Assets

NFIFO + interest pd – unpaid labor/mgt Total Revenue

Total Revenue Total Assets

Rate Of Return On Assets

Operating Profit Margin Ratio

Asset Turnover Ratio

X

Operating Profit Margin

Asset Turnover

Return On Assets (less interest adj.)

Financial Structure

Return On Equity

X =

X =Turnings/Asset Use

Leverage

DuPont System

Earnings/Efficiency

NFIFO – unpaid labor/mgtROROE = Total Equity

NFIFO + interest pd. – unpaid labor/mgt Total Assets

Total Assets Total Equity

Rate Of Return On Equity

Rate Of Return On Assets

Leverage Ratio

- interest pd.Total Assets

i-rate Adj.

= NFIFO – unpaid labor/mgt Total Assets X

Net Farm Income From Operations (NFIFO)

NFIFO = Total Revenue – Basic Costs – Non Basic Costs

sales, govt. pmts, custom work +(-) inventory changes

cash expenses +(-) accrual expense changes

labor + depreciation

+ interest expenses

NFIFO = Total Revenue – COGS – Operating Expenses – Interest

Return On Assets

Total AssetsTotal Equity

Return On Equity

X =

Leverage

Leverage is the mix of debt versus equity capital used in making profits.

- Do we have too much debt?- Do we have enough debt?- Is our debt capital generating profits?- Can our debt capital be put to better use?

OK

Too Low

Too Low

NFIFO – unpaid labor/mgt + interestTotal Revenue

Total RevenueTotal Assets

Return On Assets

Total AssetsTotal Equity

Return On Equity

X =

X =

Earnings

Turnings

Leverage

cash income +(-) inventory changes

cash expenses +(-) accrual exp changes + purch lstk Depr

labor + depreciation + interest expenses

OK

Too Low

OPMR

ATO OK

Too Low

Total Revenue =

Basic Costs =

Non Basic Costs =

OK

Too Low

- Too much labor given output- Not enough labor

- Training and Education- Better systems and

processes- Weekly/Daily staff meetings

- Performance metrics

NFIFO – unpaid labor/mgt + interestTotal Revenue

Total RevenueTotal Assets

Return On Assets

Total AssetsTotal Equity

Return On Equity

X =

X =

Earnings

Turnings

Leverage

OPMR

ATO

Too Low

OK

Too Low

OK

Too Low

- Unproductive machinery? - Buildings not being used? - Breeding livestock not producing? - Unproductive land?- Over valued assets?

Also, selling off unproductive assets and paying off debt could change your leverage position in a positive way, and also improve your ROROE!

Financial Diagnostics via DuPont. Finding the Red

Flags!

ROROE too Low

ROROA too Low

Revenues too low for costs

Unused or Under

Utilized Assets

Obsolete or Inefficient

Assets

Leverage

Wrong Kind of Debt

Not Enough Debt

OPM too Low

ATO too Low

Costs too high for Revenues

PricesProduction

QualityFacilities

ProcessesOperations

HealthLabor

RepairsTimeliness

Management

Ability to Manage Assets

Endhttp://cdp.wisc.edu/Management.htm

NFIFO+int

- unpd mgt 11.7 2007 31,157 3.4 2008 1,665 6.12 5 yr avg

OPM

÷ 4.1% 751,348 0.2% 757,926

Earnings GR

NFIFO – unpaid labor/mgtROROE = Total Equity

NFIFO – unpaid labor/mgt + interest pd.ROROA = Total Assets

NFIFO – unpaid labor/mgt + interest pd.OPMR = Total Revenue

Total RevenueATO = Total Assets

Total AssetsFinancial Structure = Total Equity

Rate Of Return On Equity

Rate Of Return On Assets

Operating Profit Margin Ratio

Asset Turnover Ratio

Leverage Ratio