*Financial Statement Analysis - DuPont & Pyramid RatiosDr. Clive Vlieland-Boddy

*

*Pyramid FormulasThese take a basic formula and expand it.They enable a basic formula to be decomposed.The most common one is DuPont

*So, How Is Money Made?Through Three Primary LeversBy being efficient with your operationsBy getting the most out of your assetsBy leveraging your moneythat is, helping your own money do bigger and better things through borrowed use of someone elses money.

*How Can I Analyze How I am Doing At Making Money? How I might make more money?By analyzing each of the three levers that leads to Return on Equity ROE:Profitability of the operationsHow efficient assets are being made to workLeverage ( the right mix of Equity to Debt)

*The basic Formula says the return that the shareholders are getting.The Return on Equity (ROE)Based on Net Earnings before dividends compared to the average shareholder funds.

How Can Return On Equity Be Expanded?

*Introducing the DuPont System for Financial Analysis

*DuPont SystemDeveloped in 1919 by a finance executive at E.I. du Pont de Nemours and CoA way of visualizing the information so that everyone can see itIs a good tool for getting people started in understanding how they can have an impact on resultsIt is simple and straightforward

*The DuPont SystemMethod to breakdown ROE into:ROA and Equity MultiplierROA is further broken down as:Profit Margin (profitability)Asset Turnover (efficiency in using the assets)Helps to identify sources of strength and weakness in current performanceHelps to focus attention on value drivers

*DuPont System What is It?The system identifies profitability as being impacted by three different levers: Earnings & efficiency in earningsAbility of your assets to be turned into profitsFinancial leverageEarningsEfficiencyLeverage

*Return on Equity - ROEThis represents the Net income generated by the Equity invested in the businessThe Formula is:

Net Income EquityThis represents $s of profit per $ invested by the shareholders.

*Basic Equation!

Equals

AB=Expand.

*Back to basic MathematicsA simple equation:

AYZYxxZB

*Back to basic MathsA simple equation:

AYZYxxZB

*Back to basic Maths

Equals

AB=

*Net IncomeTotal Equity=Net IncomeSalesXSalesTotal AssetsProfitabilityAsset Usage Efficiency Net Profit MarginROETotal Asset TurnoverXDebt RatioLeverageTotal AssetsTotal Equity

*So what does the DuPont say?DuPont analysistells us that ROE is affected bythree things: Operating efficiency, which ismeasured by profit margin.Asset use efficiency, which is measured by total asset turnover.Financial leverage ismeasured by the equity multiplier

*

*The DuPont System

*The DuPont System

*The DuPont System

*The DuPont System

*DuPont Equation

*Operating Profit MarginAsset TurnoverReturn On Assets (less interest adj.)Financial StructureReturn On EquityX=X=Income StreamInvestment StreamAsset Efficiency UsageLeverageDuPont SystemEarnings/Profitability

*Operating Profit MarginAsset TurnoverReturn On Assets (less interest adj.)Financial StructureReturn On EquityX=X=Income StreamInvestment StreamProfitabilityEfficiencyLeverageDuPont System Ratios

*Lets do the Numbers!Using Whitbread Plc 2009 and 2008 accounts

*Whitbread Plc Key FiguresSales 1,334.6Net Earnings90.3

Average Total Assets 2,495.0Average Total Equity 1,222.5

*Operating Profit MarginAsset TurnoverReturn On Assets ROAFinancial StructureReturn On EquityX=X=Efficiency/Asset UseLeverageDuPont SystemProfitabilityWe can firstly Expand ROA

*Whitbread Plc Key FiguresSales 1,334.6Net Earnings90.3

Average Total Assets 2,495.0Average Total Equity 1,222.5

* Net Income (Profits) ROA = Total Assets Net Income (Profit) Total Revenue/SalesReturn On Assets Net Profit Margin - ProfitabilityAsset Turnover Ratio - Efficiency 90.3m 1,334.6m=1,334.6m2,495m Total Revenue/Sales Total AssetsIf you delete the Total Revenues you return to ROACan be expanded to:= 90.3m 2,495m

*Whitbread Plc Key FiguresSales 1,334.6Net Earnings90.3

Average Total Assets 2,495.0Average Total Equity 1,222.5

*Operating Profit MarginAsset TurnoverReturn On Assets (less interest adj.)Financial StructureReturn On EquityX=X=Efficiency/Asset UseLeverageDuPont SystemProfitabilityNow we can look at the effect of leverage

*Whitbread Plc Key FiguresSales 1,334.6Net Earnings90.3

Average Total Assets 2,495.0Average Total Equity 1,222.5

* Net Income (Profits) ROROE = Total Equity Total Assets Total EquityReturn On Equity Leverage Ratio =XReturn On Assets Net Income (Profits) ROA = Total Assets 90.3m 2,495m 2,495m 1,222.5mIf you delete the Total Assets you return to ROE= 90.3m 1,222.5m

*Whitbread Plc Key FiguresSales 1,334.6Net Earnings90.3

Average Total Assets 2,495.0Average Total Equity 1,222.5

*Return On AssetsTotal Assets Total EquityReturn On EquityX=LeverageLeverage is the mix of debt versus equity capital used in making profits. - Do we have too much debt? - Do we have enough debt? - Is our debt capital generating profits? - Can our debt capital be put to better use?OKToo LowToo Low

*Example of DuPont

*Compare Whitbread a UK brewery against its industry

*Combination of all three factors Whitbread The IndustryProfitability 6.77% 8.10% Efficiency .535 .74 Leverage 2.04% 2.00%

Whitbread: 6.77% x .535 x 2.04% = 7.39%Industry: 8.10% x .74 x 2.00% = 11.99

Disaggregating Return on Assets

Bye for now!Im ready for some leisure time.

As a general note, it is easy to get lost by focusing on the calculation of ratios. The students probably need more help in interpretation of ratios. Instruction should include both help with calculations and guidance in interpretation.DuPont Chart and Equation - Tie the Ratios Together

Shows how profit margin, asset turnover ratio, and equity multiplier determine ROE

Shows how expense control (profit margin), efficient use of assets in production (asset turnover) and capital structure (equity multiplier) affect return on equity.

Ties together all aspects of firm - production and financing.

Notice that using more debt (and less equity) to finance assets raises the Equity Multiplier. This has two effects for stockholders.

The Equity Multiplier acts as a lever to magnify the effects of ROA on returns for stockholders. If ROA is positive, ROE is a larger positive value, but if ROA is negative ROE is a larger negative.

Raising the s magnifying effect also raises the risk for stockholders.Return on Assets is affected by two areas of operations. The Profit Margin measures the degree to which the firm controls expenses. Since expenses comprise the difference between Sales and Net Income, lowering the expenses taken out of each dollar of sales raises the Profit Margin.

At the same time, Return on Assets can be raised by producing sales by using fewer assets. Asset Turnover measures the dollar of sales produced with each dollar invested in assets. This is often thought of as sales volume.

Different industries achieve ROA in different ways. Some have low profit margins but high volume, e.g. grocery stores. Others have lower volume but are able to maintain higher profit margins, e.g. car dealerships.

**