10. An analysis of company performance using DuPont analysis Walking down the hall of your office building with a sheaf of papers in her hand, your friend and colleague, Chloe, stepped into your office and asked the following. CHLOE: 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? CHLOE: I've been reviewing the company's financial statements and looking for general ways to improve our performance, in general, and the company's return on equity, or ROE, in particular. Eric, 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 if I've missed anything. Here are the balance sheet and income statement data that Eric 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 Cash $600,000 Accounts payable Accounts receivable 1,200,000 Accruals Inventory 1,800,000 Notes payable Current assets $3,600,000 Current liabilities Long-term debt Total liabilities Common stock Net fixed assets 3,600,000 Retained earnings Total equity Total assets $7,200,000 Total debt and equity Income Statement Data $720,000 Sales $12,000,000 240,000 Cost of goods sold 7,200,000 960,000 Gross profit $4,800,000 $1,920,000 Operating expenses 3,000,000 2,400,000 EBIT $1,800,000 $4,320,000 Interest expense 403,200 720,000 EBT $1,396,800 2,160,000 Taxes 488,880 $2,880,000 Net income $907,920 $7,200,000 ! the total asset If I remember correctly, the DuPont equation breaks down our ROE into three component ratios: the net profit margin turnover ratio, and the equity multiplier And, according to my understanding of the DuPont equation and its calculation of ROE, the three ratios provide insights into the company's use of debt versus equity financing effectiveness in using the company's assets, and control over its expenses Now, let's see your notes with your ratios, and then we can talk about possible strategies that will improve the ratios. In the dropdown lists next to your values I'm going to select correct if your calculation is correct and incorrect if your calculation is incorrect. Value Correct/Incorrect 40.00 Hydra Cosmetics Inc. DuPont Analysis Value Correct/Incorrect Ratios Asset management ratio Correct Total asset turnover 11.64 Incorrect Incorrect Financial ratios Equity multiplier 1.67 Ratios Profitability ratios Gross profit margin (%) Operating profit margin (%) Net profit margin (%) Return on equity (%) Correct 12.61 35.10 Incorrect 1.67 Incorrect CHLOE: 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: Note: Do not round intermediate calculations. Round final answers to the nearest whole number. Value Hydra Cosmetics Inc. DuPont Analysis Calculation Numerator Denominator 4,800,000 1 12,000,000 1,800,000 / 12,000,000 907,920 / 12,000,000 907,920 / 2,880,000 0 0 Profitability ratios Gross profit margin (%) Operating profit margin (%) Net profit margin (%) Return on equity (%) Asset management ratio Total asset turnover Financing ratios Equity multiplier 0 0 12,000,000 / 7,200,000 2 7,200,000 / 2,880,000 3 CHLOE: I see what I did wrong in my computations. Thanks for reviewing these calculations with me. You saved me from a lot of embarrassment! Eric 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 Hydra'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 asset turnover. Use more debt financing in its capital structure and increase the equity multiplier. Increase the firm's bottom-line profitability for the same volume of sales, which will increase the company's net profit margin. Decrease the company's use of debt capital because it will decrease the equity multiplier