Wednesday, April 8, 2009

DuPont Analysis

This is easily one of my favourite financial frameworks because it is so useful and intuitive, a great combination. Even if you had a limited math background using common sense you could probably reproduce this formula (either from the bottom up or top down). Let's do it top down as it's presented in the CFA text books:

Return on Equity (RoE) = Net Income (NI) / Equity
Return on Equity = Return on Assets (RoA) x Financial Leverage (FLA)
RoA = NI / Assets
and FLA = Assets / Equity

At each stage, the formula can be further decomposed. For instance, Return on Assets can be decomposed to:

RoA = Net profit margin (NPM) x Total Asset Turnover

This formula captures the essence of operational efficiency in terms most lay people can understand. How [efficiently] are we selling (Total Asset Turnover - TAT) [with respect to the assets we use to produce our product - directly related to revenue and number of products sold at a constant price]?

The DuPont model goes on to further decompose NPM as gross product margin, tax burden and effect of 'non-operating items' etc, but even at this stage, this formula gives a good basis for common size comparison with other companies in the industry.

Let's look at each component and see if we can describe them in layman's terms:
  • Return on Equity - How much income are we making relative to the equity we put in?
  • Financial leverage - How much debt have we applied relative to our equity?
  • Return on Assets - How much income are we making relative to all the capital we put it (including debt)?
  • Total Asset Turnover - How [efficiently are we using our assets]?
  • Net Profit Margin - For each unit of good or service we sell, after the costs, how much do we keep?
  • Gross Profit Margin - Before we do accounting and pay tax, how much of each good or service do we keep for each sale?
  • Tax burden - After accounting practices, what is the effect of our current tax rate?
  • Non-operating items - Can we use depreciation and amortization to affect our tax burden?
It can quickly tell you the status of the leverage, operational efficiency and sales to identify if there are problems from a high level to determine if certain areas warrant a deeper investigation. No calculus required.


Anonymous said...

You've got Asset Turnover wrong. It is the Firms use of assets to create revenue.

Joshua Wong said...

I have over simplified my statement. I've made the corrections in bold. I had previously said that Total Asset Turnover was "How much product is sold". This isn't entirely accurate.

I was trying to illustrate the directly proportional relationship between high sales numbers and high revenue (which would result in a higher Total Asset Turnover) assuming a constant price.

The TAT ratio is calculated as Revenue over Total Assets. Holding price for each unit the same, the higher the number of units sold, the higher the revenue and the higher the total asset turnover (assuming the same asset value).

Thanks for the clarification.

Joshua Wong said...

And just to be clear:

I wanted to make a distinction between adjusting the capital structure and selling more units (in terms of how lay people think of business and management decisions).

That is to say that Assets would only really change through the capital structure and leverage component (FLA) assuming a constant equity (by increasing debt).

Then the only way to change ROA for a constant value of assets is to increase sales.

Hope that justifies my oversimplification :)