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Articles Written On DuPont Model

slang — Wed, 21 Mar 2007 16:34:12 +0000

The following are some articles on DuPont Model

DUPONT System –Overview Of Return On Assets & Return On Equity

DUPONT System-A Matter Of Leverage Or Is It Financial Efficiency

DuPont System: A Matter of Leverage or Is It FINANCIAL EFFICIENCY?

slang — Sun, 02 Apr 2006 11:07:14 +0000

In my earlier article on the DuPont System, I put forth what the DuPont System is and attempted to elaborate on its three (3) components. There should not have been any problems in understanding Return on Assets (ROA) since ROA essentially consists of profitability coupled with the efficiency of using the company’s assets to generate the desired level of ROA %.

But, what about this so-called Financial Leverage Multiplier (FLM), which is defined as the ratio of Total Assets to Shareholders’ Equity – namely the degree of reliance on financing from borrowing and bonds?

Let’s us go back to basics. A higher Total Assets to Shareholders’ Equity means a higher level of leverage as the denominator, the shareholders have less stake in the total assets. For example, total assets is $1million and shareholders’ funds might be a $500,000 which is 2x compared to say a shareholder fund of $1,000 which is 100x which will then lead the company to extremely high gearing exposure. During a recession, when returns from business dip, it will definitely not able to service its interest from these high borrowings.

However, if we were able to MANAGE the efficiency of leverage or the level of financial efficiency we can definitely see a rise in Return on Equity, which all shareholders love to have (on the proviso that ROA % is also on a rising trend)

Illustration:

Yr	(a) Assets Turnovers Sales/Avg Assets	x	(b) Return on Sales Net Income/Sales	=	© ROA Net Income/Avg Assets	x	(d) Financial Leverage Avg Assets/Avg Equity	=	(e) ROE Net Income/Avg Equity
1	1.5	x	4.1%	=	6.2%		2.5	=	15.5%
2	1.8	x	5.2%	=	9.4%		3.0	=	28.2%
3	2.3	x	7.1%	=	16.3%		3.1	=	50.5%

If you were to look at the above illustration, if you are able to manage a higher efficient use of your company’s assets and its profitability level, and simultaneously able to efficiently use the Financial Leverage to your advantage, you can definitely see the ROE % increases many fold.

However, what if we have another case where there is no improvement at all for ROA %, BUT the FLM has increased dramatically and hence ROE% increases many folds? This I believe is a blatant case of using “others people’s money to roll”. This will happen when a high rise politician/powerful businessman can borrow as much as he wants.

Incidentally, this use of infinite leverage fueled the Leveraged Buyout (LBO) era of the 1980s in the US. So long as the acquired company’s Return on Assets % exceeded the cost of funds, the entrepreneur will make money. This is normally done by disposing off the acquired company’s assets so as to increase it ROA %. However, most LBO’s failed either because the businesses could not earn enough on its Return on Assets % to service their costs of funds and other cash outflows or because the assets managed could not be reduced as planned.

Nowadays, bankers are more cautious by stipulating certain covenants like higher levels of shareholder funds to total capital in their lending agreements.

DuPont System: Overview & ROA & ROE

slang — Tue, 21 Mar 2006 08:00:59 +0000

The DuPont System was developed by DuPont Corporation to dissect a firm’s financial statement, so as to assess its financial condition.

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.

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.

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

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.

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.

Therefore, the DuPoint system enables management to look at both ROA & ROE so as to provide a clearer picture of management effectiveness,

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.