Question

An analysis of company performance using DuPont analysis

A sheaf of papers in her hand, your friend and colleague, Madison, steps into your office and asked the following.

MADISON: Do you have 10 or 15 minutes that you can spare?

YOU: Sure, I’ve got a meeting in an hour, but I don’t want to start something new and then be interrupted by the meeting, so how can I help?

MADISON: I’ve been reviewing the company’s financial statements and looking for ways to improve our performance, in general, and the company’s return on equity, or ROE, in particular. Xavier, my new team leader, suggested that I start by using a DuPont analysis, and I’d like to run my numbers and conclusions by you to see whether I’ve missed anything.

Here are the balance sheet and income statement data that Xavier gave me, and here are my notes with my calculations. Could you start by making sure that my numbers are correct?

YOU: Give me a minute to look at these financial statements and to remember what I know about the DuPont analysis.

Balance Sheet Data	Income Statement Data
Cash	$1,300,000	Accounts payable	$1,560,000	Sales	$26,000,000
Accounts receivable	2,600,000	Accruals	520,000	Cost of goods sold	13,000,000
Inventory	3,900,000	Notes payable	2,080,000	Gross profit	13,000,000
Current assets	7,800,000	Current liabilities	4,160,000	Operating expenses	6,500,000
		Long-term debt	3,640,000	EBIT	6,500,000
		Total liabilities	7,800,000	Interest expense	686,400
		Common stock	1,300,000	EBT	5,813,600
Net fixed assets	5,200,000	Retained earnings	3,900,000	Taxes	1,453,400
		Total equity	5,200,000	Net income	$4,360,200
Total assets	$13,000,000	Total debt and equity	$13,000,000

If I remember correctly, the DuPont equation breaks down our ROE into three component ratios: the NET PROFIT MARGIN , GROSS PROFIT MARGIN the total asset turnover ratio, and the Equity Multiplier, EQUITY RATIO .  

And, according to my understanding of the DuPont equation and its calculation of ROE, the three ratios provide insights into the company’suse of debt versus equity financing or MANAGEMENT OF SHARES AND SALES PRICE , effectiveness in using the company’s assets, and MANGEMENT OF ITS LIQUITY AND TAX RECORDS/CONTROL OVER ITS EXPENSIVE .

Canis Major Veterinary Supplies Inc. DuPont Analysis

Ratios	Value	Correct/Incorrect	Ratios	Value	Correct/Incorrect
Profitability ratios			Asset management ratio
Gross profit margin (%)	50.00		Total assets turnover	2.00
Operating profit margin (%)	22.36
Net profit margin (%)	33.54		Financial ratios
Return on equity (%)	112.02		Equity multiplier	1.67

Canis Major Veterinary Supplies Inc. DuPont Analysis

Ratios	Value	Correct/Incorrect	Ratios	Value	Correct/Incorrect
Profitability ratios			Asset management ratio
Gross profit margin (%)	50.00		Total assets turnover	2.00
Operating profit margin (%)	22.36
Net profit margin (%)	33.54		Financial ratios
Return on equity (%)	112.02		Equity multiplier	1.67

MADISON: OK, it looks like I’ve got a couple of incorrect values, so show me your calculations, and then we can talk strategies for improvement.

YOU: I’ve just made rough calculations, so let me complete this table by inputting the components of each ratio and its value:

Do not round intermediate calculations and round your final answers up to two decimals.

Canis Major Veterinary Supplies Inc. DuPont Analysis

Ratios	Calculation		Value
Profitability ratios	Numerator		Denominator
Gross profit margin (%)		/		=
Operating profit margin (%)		/		=
Net profit margin (%)		/		=
Return on equity (%)		/		=
Asset management ratio
Total assets turnover		/		=
Financial ratios
Equity multiplier		/		=

MADISON: I see what I did wrong in my computations. Thanks for reviewing these calculations with me. You saved me from a lot of embarrassment! Xavier would have been very disappointed in me if I had showed him my original work.

So, now let’s switch topics and identify general strategies that could be used to positively affect Canis Major’s ROE.

YOU: OK, so given your knowledge of the component ratios used in the DuPont equation, which of the following strategies should improve the company’s ROE?

Check all that apply.

Increase the cost and amount of assets necessary to generate each dollar of sales because it will increase the company’s total assets turnover.

Use more debt financing in its capital structure and increase the equity multiplier.

Use more equity financing in its capital structure, which will increase the equity multiplier.

Decrease the company’s use of debt capital because it will decrease the equity multiplier.

MADISON: I think I understand now. Thanks for taking the time to go over this with me, and let me know when I can return the favor.

Answer 1

Probability Ratios:

Gross Profit Margin= Gross Profit/Sales= 13000000/26000000= 50%

Operating Profit Margin= EBIT/Sales= 6500000/26000000= 25%

Net Profit Margin= Net Income/Sales= 4360200/26000000= 16.77%

Return on Equity= Net Income/Total Equity= 4360200/5200000= 83.85%

Asset Management Ratios:

Total Asset Turnover= Sales/Total Assets= 26000000/13000000= 2

Financial Ratios:

Equity Multiplier= Total Assets/Total Equity= 13000000/5200000= 2.5

For improving the company's ROE, Use more debt financing in its capital structure, and increase the equity multiplier. (Option B)

All the other suggestions are false, as Option A decreases total asset turnover, Option C decreases equity multiplier and Option D decreases company's ROE.