business finance

Business FinanceMB-664DuPont Model

MB 664 UVG-TAMU May 2009

Profit Improvement


Du Pont FormulaROA can be broken down into margin and turnoverGain insight into planning for profit improvementImprove marginImprove turnoverImprove both!


Improve MarginReducing expensesUsing less costly materialsAutomation to improve productivityReview fixed costs (advertising, R&D, management development programs, etc.)Raising pricesRequires pricing powerAlso requires brand loyaltyEasier for firms with unique high-quality goods or services


Improve TurnoverIncrease sales while holding investment in assets relatively constantDispose of obsolete and redundant assetsSpeed up collections of receivablesEvaluate credit terms and policiesIdentify unused fixed assetsUse idle cash to repay outstanding debts or invest in profit-producing activities


Cost of goods soldSelling expensesAdministrative expensesCashAccounts receivableInventories Marketable securitiesOther current assetsLandBuildingsMachineryEquipment


Cost of goods soldSelling expensesAdministrative expensesCashAccounts receivableInventories Marketable securitiesOther current assetsLandBuildingsMachineryEquipmentTotalcostCurrentassetsFixed assets


Cost of goods soldSelling expensesAdministrative expensesCashAccounts receivableInventories Marketable securitiesOther current assetsLandBuildingsMachineryEquipmentSalesTotalcostCurrentassetsFixed assetsNet incomeTotalassets


Cost of goods soldSelling expensesAdministrative expensesCashAccounts receivableInventories Marketable securitiesOther current assetsLandBuildingsMachineryEquipmentSalesTotalcostCurrentassetsFixed assetsNetprofitmarginTotalassetturnoverTotalassetsSalesNet incomeSales


Cost of goods soldSelling expensesAdministrative expensesCashAccounts receivableInventories Marketable securitiesOther current assetsLandBuildingsMachineryEquipmentSalesTotalcostCurrentassetsFixed assetsNetprofitmarginTotalassetturnoverTotalassetsSalesNet incomeSalesROA


Cost of goods soldSelling expensesAdministrative expensesCashAccounts receivableInventories Marketable securitiesOther current assetsLandBuildingsMachineryEquipmentSalesTotalcostCurrentassetsFixed assetsNetprofitmarginTotalassetturnoverTotalassetsSalesNet incomeSalesROAThe Du Pont formula


Modified Du Pont FormulaUse of borrowed funds can magnify returns to equity. To see thisConsider the following definitions:ROE = Net income EquityorROE = (Net income Total assets) (Total assets Equity)orROE = ROA Equity multiplier

where:Equity multiplier = Total assets EquityorEquity multiplier = 1 (1 Debt ratio)


An ExampleAssume the following values:Sales (S) = $50,000Net income (NI)= $18,000Total assets (TA) = $100,000Equity (E) = $45,000

Using the previous definitions:ROE = NI E = $18,000 $45,000 = 40%

Equity multiplier = TA E = $100,000 $45,000 = 2.22 orEquity multiplier = 1 (1 Debt TA) = 1 (1 .55) = 2.22ROE = NI TA Equity multiplier = 18% 2.22 = 40%


Continuation of Example If the firm used only equity to fund its operation, the ROE and ROA would be identical, or:

ROE = NI E = $18,000 $100,000 = 18%ROA = NI TA = $18,000 $100,000 = 18%

However, 45% of the firms capital was supplied by creditors, so: Equity multiplier = 1 (1 Debt TA) = 1 (1 .55) = 2.22ROE = NI TA Equity multiplier = 18% 2.22 = 40%

This illustrates the potential benefits to the use of leverage.


Another ExampleConsider two firms each having $800,000 in total assets but one firm having debt of $400,000, or Firm A Firm BTotal assets$800,000$800,000Total debt 0 400,000Equity 800,000 400,000

Each firm has an operating income or EBIT of $300,000 but firm B has interest expenses of $40,000, so:Operating income$300,000$300,000Interest expense 0 40,000Profit before taxes 300,000 260,000Taxes at 30% 90,000 78,000Net Income$210,000$182,000


Continuation of ExampleThe rate of return on equity for these two firms therefore would be:

Firm A Firm BTotal assets$800,000$800,000Total debt 0 400,000Equity 800,000 400,000

Net Income$210,000$182,000ROE 26.25% 45.5%

Conclusion:Although the absence of debt allows firm A to register higher profit after taxes, the owner(s) of firm B earn a significantly higher return on equity capital invested in the firm.


DuPont formula SummaryBecause it links several critical ratios, the DuPont formula allows you to examine how a firm generates its ROE.

NI = net incomeNPM = net profit margin = NI salesTA = total assetsEM = equity multiplier = 1 (1 debt ratio)TAT = total asset turnover = sales TAROE = NPM TAT EMorROE = (NI TA) EM


DuPont formula SummaryBecause it links several critical ratios, the DuPont formula allows you to examine how a firm generates its ROE.

NI = $18,000NPM = net profit margin = NI S = 0.36TA = $100,000EM = equity multiplier = 1 (1 debt ratio) = 2.22TAT = total asset turnover = S TA = 0.5ROE = NPM TAT EM = .36 .5 2.22 = .40orROE = (NI TA) EM = .18 2.22 = .40


Analyzing DuPont formulaA firm is said to be in a sound financial condition if: It has a high net profit margin (NPM), which signals strong operating management.

It has a high total asset turnover (TAT), which signals strong asset management,

It has a low equity multiplier (EM), which signals strong capital management in the presence of low and stable cost of debt capital.


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