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.