As a shareholder, the return a company is providing on your funds (return on equity) is a key consideration in judging the performance of the firm's managers. DuPont analysis provides a framework to show how both the management of the company's operation and its financial structure impacts return on equity. DuPont analysis derives its name from the DuPont corporation, which developed and began using this approach in the early 1920s.
The DuPont analysis for Sara Lee uses data from the 1988 annual report. The shaded boxes represent those in which data must be entered. We have taken advantage of Microsoft Excel's ability to draw the various boxes and lines, but if you are using Lotus 1-2-3 you must skip the boxes and use dashes, > and | characters to draw the relationships between the various calculations and ratios.When entering these and other characters that might be interpreted as mathematical operations, you must precede the symbol with a character to let the program know that you are entering a label instead of a number. In Lotus 1-2-3, you would use the, ', or " symbols to inform the program that you are entering text, depending on if it should be centered, aligned on the left side of the cell, or aligned on the right side of the cell. In Excel, you would have to enclose the item in double quotes and precede the statement with an equals (=) sign.
The top portion of the worksheet deals primarily with the income statement (good operations management), while the bottom portion emphasizes the balance sheet (prudent use of financial leverage). This separation highlights that return on equity is affected by firm profitability and balance sheet structure.
Sales, interest income (other income), cost of goods sold, selling and administration expenses, interest expense, and taxes are entered from the income statement to determine net earnings (or net income on some financial statements). Net earnings divided by sales gives us the profit margin. It might be worth noting that Sara Lee did not break out depreciation as a separate line item on its income statement, so we left that cell blank. Data from the statement of cash flows or even changes in accumulated depreciation can by used to determine the depreciation, but for the purpose of DuPont analysis it was not important to break the information out. As you work with different companies, you will find slight variations in how they present their financial statements. The worksheet, with its other categories, should prove flexible enough to deal with the variations or it can be easily modified to conform to the variations.
Asset data from the balance sheet is entered to determine the total assets. For Sara Lee, other assets include trademarks, investments in unconsolidated companies and intangibles. Dividing sales by total assets gives us asset turnover. Asset turnover times profit margin provides the return on assets.
The liabilities from the balance sheet are entered to determine the total debt. For Sara Lee, other current liabilities consist of notes payable, current maturities of long-term debt and current obligations under capital leases. The other liabilities box includes long-term obligations under capital leases, deferred income taxes and other liabilities. Total debt divided by total assets provides the financial leverage figure. Financial leverage refers to the percentage of total assets financed through debt.
Dividing return on assets by one minus financial leverage computes the return on equity. Examining the interplay between the ratios is the key behind DuPont Analysis. Return on equity can be increased through higher return on assets or a higher degree of leverage--more debt relative to assets. The high degree of financial leverage is how buyout artists hope to make big profits when they take on huge amounts of debt in acquiring companies. The risk in the strategy is that the company will not generate enough cash flow to cover the interest payments. Proper use of financial leverage can help increase the return on equity. If Sara Lee had no debt its return on equity would be the same as its return on assets--6.48%.
Return on assets can be increased with higher profit margins or higher asset turnover. Margins are improved by lowering expenses relative to sales. Asset turnover can be improved by selling more goods with a given level of assets. This is why companies try to divest assets (operations) that do not generate a high degree of sales relative to the value of the assets, or assets that are decreasing their sales generation.
When examining profit margins or asset turnover, it is important to consider industry trends and compare how a company is doing within its industry. A supermarket chain, for example, would tend to have low profit margins, but make it up in high turnover.
DuPont analysis highlights the interaction between a company's operation and its capital structure. It gives investors a tool with which to judge the performance of management on a few levels. lt also helps to remind investors that ratios should not be examined in a vacuum, but studied to see how they affect the overall organization.
