The Du Pont System The returns on investment ratios give us a “bottom line” on the perfor-
The Du Pont System The returns on investment ratios give us a “bottom line” on the perfor-
mance of a company, but don’t tell us anything about the “why” behind this performance. For an understanding of the “why,” the analyst must dig a bit deeper into the financial statements. A method that is useful in examining the source of performance is the Du Pont system. The Du Pont system is a method of breaking down return ratios into their com- ponents to determine which areas are responsible for a firm’s perfor- mance. To see how it’s used, let’s take a closer look at the first definition of the return on assets:
Earnings before interest and taxes
Basic earning power = ---------------------------------------------------------------------------------------
Total assets Suppose the return on assets changes from 20% in one period to
10% the next period. We do not know whether this decreased return is due to a less efficient use of the firm’s assets—that is, lower activity—or to less effective management of expenses (i.e., lower profit margins). A lower return on assets could be due to lower activity, lower margins, or both. Because we are interested in evaluating past operating performance to evaluate different aspects of the management of the firm and to pre- dict future performance, knowing the source of these returns is valuable.
Let’s take a closer look at the return on assets and break it down into its components: measures of activity and profit margin. We do this by relating both the numerator and the denominator to sales activity. Divide both the numerator and the denominator of the basic earning power by sales:
FINANCIAL STATEMENT ANALYSIS
Earnings before interest and taxes Sales ⁄
Basic earning power = --------------------------------------------------------------------------------------------------------
Total assets Sales ⁄ which is equivalent to: Earnings before interest and taxes Sales
Basic earning power = --------------------------------------------------------------------------------------- ------------------------------
Total assets This says that the earning power of the company is related to profitabil-
Sales
ity (in this case, operating profit) and a measure of activity (total asset turnover).
Basic earning power = (Operating profit margin) (Total asset turnover)
If we are analyzing a change in basic earning power, we therefore know that we could look at this breakdown to see the change in its com- ponents: operating profit margin and total asset turnover.
This method of analyzing return ratios in terms of profit margin and turnover ratios, referred to as the Du Pont System, is credited to the E.I. Du Pont Corporation, whose management developed a system of break- ing down return ratios into their components. 2
Let’s look at the return on assets of Fictitious for 1998 and 1999. Its returns on assets were 20% in 1998 and 18.18% in 1999. We can decompose the firm’s returns on assets for the two years, 1998 and 1999, to obtain:
Year Basic Earning Power Operating Profit Margin Total Asset Turnover
18.18 20.00 0.9091 times We see that operating profit margin declined from 1998 to 1999, yet
asset turnover improved slightly, from 0.9000 to 0.9091. Therefore, the return-on-assets decline from 1998 to 1999 is attributable to lower profit margins.
The return on assets can be broken down into its components in a similar manner:
2 American Management Association, Executive Committee Control Charts, AMA Management Bulletin No. 6, 1960, p. 22.
Financial Ratio Analysis
Net income Sales
Return on assets = ------------------------------ ------------------------------
Sales Total assets or
Return on assets = (Net profit margin) (Total asset turnover) We can relate the basic earning power ratio to the return on assets,
recognizing that:
Net income = Earnings before tax (1 − Tax rate) Net income = Earnings before interest and taxes
× --------------------------------------------------------------------------------------- ( – 1 Tax rate ) Earnings before interest and taxes
Earnings before taxes
↑ equity’s share of earnings tax retention %
The ratio of earnings before taxes to earnings before interest and taxes reflects the interest burden of the company, where as the term (1 − tax rate) reflects the company’s tax burden. Therefore,
Earnings before interest and taxes Sales Return on assets = --------------------------------------------------------------------------------------- ------------------------------
Sales
Total assets
Earnings before taxes × --------------------------------------------------------------------------------------- ( – 1 Tax rate ) Earnings before interest and taxes
or Return on assets = ( Operating profit margin ) Total asset turnover ( )
× ( Equity’s share of earnings ) Tax retention % ( ) The breakdown of a return-on-equity ratio requires a bit more decom-
position because instead of total assets as the denominator, we want to use shareholders’ equity. Because activity ratios reflect the use of all of the assets, not just the proportion financed by equity, we need to adjust the activity ratio by the proportion that assets are financed by equity (i.e., the ratio of the book value of shareholders’ equity to total assets):
FINANCIAL STATEMENT ANALYSIS
Total assets
Return on equity = ( Return on assets ) ----------------------------------------------------
Shareholders’ equity
Net income
Sales
Total assets
Return on equity = ------------------------------ ------------------------------ ----------------------------------------------------
Sales Total assets Shareholders’ equity equity multiplier
The ratio of total assets to shareholders’ equity is referred to as the equity multiplier. The equity multiplier, therefore, captures the effects of how a company finances its assets, referred to as its financial lever- age. Multiplying the total asset turnover ratio by the equity multiplier allows us to break down the return-on-equity ratios into three compo- nents: profit margin, asset turnover, and financial leverage. For example, the return on equity can be broken down into three parts:
Return on equity = (Net profit margin)(Total asset turnover) (Equity multiplier)
Applying this breakdown to Fictitious for 1998 and 1999:
Total Debt Equity Year
Return on Net Profit
Total Asset
Equity Margin
Turnover
to Assets Multiplier
45.45% 1.8332 We see that the return on equity decreased from 1998 to 1999 because
of a lower operating profit margin and less use of financial leverage. We can decompose the return on equity further by breaking out the equity’s share of before-tax earnings (represented by the ratio of earnings before and after interest) and tax retention percent:
Earnings before interest and taxes Sales
Return on equity = --------------------------------------------------------------------------------------- ------------------------------
Total assets
Sales
Earnings before taxes × --------------------------------------------------------------------------------------- ( – 1 Tax rate ) Earnings before interest and taxes
× ---------------------------------------------------- Total assets Shareholders’ equity
Financial Ratio Analysis
This decomposition allows the financial analyst to take a closer look at the factors that are controllable by a company’s management (e.g., asset turnover) and those that are not controllable (e.g., tax retention). As you can see, the breakdowns lead the analyst to information on both the balance sheet and the income statement. And this is not the only breakdown of the return ratios—further decomposition is possible.
Parts
» Financial Management and Analysis
» SECURITIES MARKETS The primary function of a securities market—whether or not it has a
» Stock Exchanges Stock exchanges are formal organizations, approved and regulated by
» Stock Market Indicators Stock market indicators have come to perform a variety of functions,
» Efficient Markets Investors do not like risk and they must be compensated for taking on
» THE FEDERAL RESERVE SYSTEM The United States has a central monetary authority known as the Fed-
» The Fed and the Money Supply Financial managers and investors are interested in the supply and
» Deposit Institutions Traditionally, the United States has had several types of deposit institu-
» Investment Banking The primary market involves the distribution to investors of newly
» Interest Rates and Yields Because bonds are traded in the secondary market, the price of the bond
» The Risk Premium Market participants talk of interest rates on non-Treasury securities as
» OPTIONS An option is a contract in which the writer of the option grants the
» Buying Call Options The purchase of a call option creates a position referred to as a long call
» Buying Put Options The buying of a put option creates a financial position referred to as a
» CAP AND FLOOR AGREEMENTS There are agreements available in the financial market whereby one
» I n assessing a company’s current and future cash flows, the financial
» Depreciation for Tax Purposes For accounting purposes, a firm can select a method of depreciation
» Capital Gains We tend to use the term “capital gain” loosely to mean an increase in the
» Current assets (also referred to as circulating capital and working
» Noncurrent Assets Noncurrent assets are assets that are not current assets; that is, it is not
» Deferred Taxes Along with long-term liabilities, the analyst may encounter another
» THE INCOME STATEMENT An income statement is a summary of the revenues and expenses of a
» THE STATEMENT OF CASH FLOWS The statement of cash flows is a summary over a period of time of a
» T he notion that money has a time value is one of the most basic con-
» DETERMINING THE PRESENT VALUE Now that we understand how to compute future values, let’s work the
» Shortcuts: Annuities There are valuation problems that require us to evaluate a series of level
» THE CALCULATION OF INTEREST RATES
» T here are a number of factors that affect a stock’s price and its value to
» Dividend Valuation Model If dividends are constant forever, the value of a share of stock is the
» Returns on Common Stock As we saw in the preceding section, the value of a stock is the present
» Straight Coupon Bond Suppose you are considering investing in a straight coupon bond that:
» Returns on Bonds If you invest in a bond, you realize a return from the interest it pays (if
» Coupon Bonds The present value of a bond is its current market price, which is the dis-
» Callable Bonds Some bonds have a feature, referred to as a call feature, that allows the
» RISK Whenever you make a financing or investment decision, there is some
» Financial Risk When we refer to the cash flow risk of a security, we expand our con-
» Reinvestment Rate Risk Another type of risk is the uncertainty associated with reinvesting cash
» Interest Rate Risk Interest rate risk is the sensitivity of the change in an asset’s value to
» Currency Risk In assessing the attractiveness of an investment, we estimated future cash
» 5 (Continued) Portfolio of Investment C and Investment D
» Portfolio Size and Risk What we have seen for a portfolio with two assets can be extended to
» I n Chapters 8 through 10, we discussed and practiced techniques for
» The Cost of Debt Because Congress allows you to deduct from your taxable income the
» The Cost of Common Stock The cost of common stock is the cost of raising one more dollar of com-
» INTEGRATIVE EXAMPLE: ESTIMATING THE COST OF CAPITAL FOR DUPONT
» CAPITAL BUDGETING Because a firm must continually evaluate possible investments, capital
» Investment Cash Flows When we consider the cash flows of an investment we must also consider
» Asset Disposition At the end of the useful life of an asset, the firm may be able to sell it or
» Change in Expenses When a firm takes on a new project, the costs associated with it will
» Putting It All Together Here’s what we need to put together to calculate the change in the firm’s
» The Analysis To determine the relevant cash flows to evaluate this expansion, let’s
» The Problem The new equipment costs $300,000 and is expected to have a useful life of
» T he value of a firm today is the present value of all its future cash
» Payback Period The payback period for a project is the length of time it takes to get your
» Discounted Payback Period The discounted payback period is the time needed to pay back the origi-
» Net Present Value If offered an investment that costs $5,000 today and promises to pay
» Net Present Value Decision Rule
» Profitability Index The profitability index (PI) is the ratio of the present value of change in
» Stand-Alone versus Market Risk If we have some idea of the uncertainty associated with a project’s
» Sensitivity Analysis Estimates of cash flows are based on assumptions about the economy,
» Simulation Analysis Sensitivity analysis becomes unmanageable if we change several factors
» Options on Real Assets The valuation of stock options is rather complex, but with the assis-
» OVERVIEW OF DEBT OBLIGATIONS In a debt obligation, the borrower receives money in exchange for a
» Repayment Schedule Term loans are usually repaid in installments either monthly, quarterly,
» Interest In the United States, interest is typically paid twice a year at six month
» Debt Retirement By the maturity date of the bond, the issuer must pay off the entire par
» Rating Systems In all systems the term high grade means low default risk, or conversely,
» S uppose you buy a new car that costs $20,000 and you pay cash for it.
» Limited Liability The corporate form of doing business is attractive to owners of a busi-
» Stock Ownership We can classify a corporation according to whether its shares of stock
» Voting Rights Common shareholders are generally granted rights to
» Corporate Democracy Corporate democracy gives owners of the corporation a say in how to
» Methods of Repurchasing Stock
» Dividends Although a firm’s board of directors declares a dividend on its preferred
» Sinking Funds Because there is no legal obligation to pay the preferred dividend and
» DEBT VERSUS EQUITY The combination of debt and equity used to finance a firm’s projects is
» CAPITAL STRUCTURE AND TAXES We’ve seen how the use of debt financing increases the risk to owners;
» Interest Tax Shield An interesting element introduced into the capital structure decision is
» Unused Tax Shields The value of a tax shield depends on whether the firm can use an interest
» PUTTING IT ALL TOGETHER As a firm increases the relative use of debt in the capital structure, its
» A s we saw in Part Three, managers base decisions about investing in
» CASH MANAGEMENT Cash flows out of a firm as it pays for the goods and services it pur-
» The Baumol Model The Baumol Model is based on the Economic Order Quantity (EOQ)
» The Miller-Orr Model The Baumol Model assumes that cash is used uniformly throughout the
» The Check Clearing Process The process of receiving cash from customers involves several time-
» RECEIVABLES MANAGEMENT When a firm allows customers to pay for goods and services at a later
» Captive Finance Subsidiaries Some firms choose to form a wholly-owned subsidiary—a corporation
» The Economic Order Quantity Model The Economic Order Quantity (EOQ) model helps us determine what
» Just-in-Time Inventory The goal of the just-in-time (JIT) inventory model is to cut down on the
» Monitoring Inventory Management We can monitor inventory by looking at financial ratios in much the
» Add-on-interest Another way of stating interest is with add-on interest, where the total
» Trade Credit Trade credit is granted by a supplier to a customer purchasing goods or
» Commercial Paper Commercial paper is an unsecured promissory note with a fixed matu-
» Types of Inventory Financing There are several different types of loan arrangements that involve
» SPECIALIZED COLLATERALIZED BORROWING ARRANGEMENT FOR FINANCIAL INSTITUTIONS
» RATIOS AND THEIR CLASSIFICATION
» RETURN-ON-INVESTMENT RATIOS Return-on-investment ratios compare measures of benefits, such as earn-
» The Du Pont System The returns on investment ratios give us a “bottom line” on the perfor-
» LIQUIDITY Liquidity reflects the ability of a firm to meet its short-term obligations
» PROFITABILITY RATIOS We have seen that liquidity ratios tell us about a firm’s ability to meet its
» Using a Benchmark To interpret a firm’s financial ratios we need to compare them with the
» INTEGRATIVE EXAMPLE: FINANCIAL ANALYSIS OF WAL-MART STORES 6
» Dilutive Securities For a company having securities that are dilutive—meaning they could
» ANALYSTS’ FORECASTS There are many financial services firms offering projections on different
» PRICE-EARNINGS RATIO Many investors are interested in how the earnings are valued by the mar-
» FREE CASH FLOW Cash flows without any adjustment may be misleading because they do
» NET FREE CASH FLOW There are many variations in the calculation of cash flows that are used
» Using Cash Flow Information The analysis of cash flows provides information that can be used along
» THE GLOBAL ECONOMY Many countries export a substantial portion of the goods and services
» FOREIGN CURRENCY Doing business outside of one’s own country requires dealing with the cur-
» The Euro The European Union consists of 15 European member countries that
» Global Equity Market In 1985, Euromoney surveyed several firms that either listed stock on a
» Currency Swaps When issuing bonds in another country where the bonds are not denom-
» Currency Option Contracts In contrast to a forward or futures contract, an option gives the option
» A s an alternative to the issuance of a corporate bond, a corporation
» WHAT RATING AGENCIES LOOK AT IN RATING ASSET-BACKED SECURITIES
» Third-Party Guarantees Perhaps the easiest form of credit enhancement to understand is insur-
» EXAMPLE OF AN ACTUAL STRUCTURED FINANCE TRANSACTION
» Accounting for Capital Leases
» FEDERAL INCOME TAX REQUIREMENTS FOR TRUE LEASE TRANSACTIONS
» Direct Cash Flow from Leasing When a firm elects to lease an asset rather than borrow money to pur-
» S tructured financing is a debt obligation that is backed by the value of
» CREDIT IMPACT OBJECTIVE While the sponsor or sponsors of a project financing ideally would pre-
» A business that maximizes its owners’ wealth allocates its resources
» Budgeting In budgeting, we bring together analyses of cash flows, projected income
» Taxes and Transaction Costs The Black-Scholes option pricing model ignores taxes and transaction
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