May 3rd, 2009
Below article looks at a very old & useful analytical tool often used in Ratio Analysis/Interpretation of financial statements namely the DuPont System/Model.
It explains what is this model and the benefits of using this model for ratio analysis.
WHAT IS DUPONT SYSTEM/MODEL
1. The DuPont System was developed by DuPont Corporation to dissect a firm’s financial statement, so as to assess its financial condition.
2. It merges the Income Statement and Balance Sheet into two summary measures of profitability: Return On Total Assets (ROA) and Return On Equity (ROE). The top portion focuses on Income Statement & bottom on balance sheet.
3. Its allow us to break ROE into 3 components:
· as a Profit on Sales,
· as an efficiency of asset-use, and
· finally on use-of-leverage
By breaking it into 3 components, we can obtain a very detailed analysis of the financial health of the company.
1.0 By analysing the profitability and then with the total assets turnover on the efficiency of asset-use, we can get a Return on Total Assets (ROA).
· ROA = Net Income after Tax/Sales(a) X Sales/Total Assets (Assets Turnover)(b)
(a) denotes the profit margin whilst
(b) denotes how well management use the total assets of the company in terms of number of times the assets turn around in term of the sales
2.0 An added element or component is the Financial Leverage Multiplier. The Financial Leverage Multiplier (FLM) is the ratio of Total Assets to Shareholders’ Equity namely the degree of reliance on financing from borrowing and bonds.
The FLM transforms ROA into Return On Equity (ROE), which is ROA X FLM = ROE.
3.0 If we look at ROE alone (net income / owners’ equity), it doesn’t say much about how well a company uses its financing from borrowing and bonds.
However, if were to look at ROA (net income/ total assets financed by both debt and equity), this can help us to see how well a company puts both these forms of financing to use.
BENEFIT OF USING THE DUPONT MODEL
The DuPoint system enables management to look at both ROA & ROE to provide a clearer picture of management effectiveness
It reconciles both ROA and ROE meaning that:
· If ROA is sound and debt levels are reasonable, a strong ROE is a solid signal that managers are doing a good job of generating returns from shareholders’ investments,
· ROE is a “hint” that management is giving shareholders more for their money. On the other hand, if ROA is low or the company is carrying a lot of debt, a high ROE can give investors a false impression about the company’s fortunes
Click here to understand basic of:
Return on Assets(ROA) and Return on Equity (ROE)
[ see the snapshot diagram of Du Point Strategic Profit Model which integrates margin management, asset management and financial management ]