9. An analysis of company performance using DuPont analysis A sheaf of papers in his hand, your friend and colleague, Landon, steps into your office and asked the following LANDON: 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? LANDON: 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. Amelia, 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 Amelia 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 $700,000 Income Statement Data Sales $14,000,000 $840,000 Accounts payable Accruals 1,400,000 280,000 7,000,000 Accounts receivable Inventory Current assets 2,100,000 4,200,000 1,120,000 2,240,000 Cost of goods sold Gross profit Operating expenses EBIT Notes payable Current liabilities Long-term debt Total liabilities 7,000,000 3,500,000 3,640,000 3,500,000 5,880,000 571,200 Interest expense EBT 980,000 2,928,800 2,940,000 Taxes 732,200 Net fixed assets Common stock 5,600,000 Retained earnings Total equity $9,800,000 Total debt and equity 3,920,000 $9,800,000 Net income $2,196,600 Total assets If I remember correctly, the DuPont equation breaks down our ROE into three component ratios: t , the total asset turnover ratio, and the And, according to my understanding of the DuPont equation and its calculation of ROE, the three ratios provide insights into the company's effectiveness in using the company's assets, and Now, let's see your notes with your ratios, and then we can talk about possible strategies that will improve the ratios. I'm going to check the box to the side of your calculated value if your calculati is correct and leave it unchecked if your calculation is incorrect. Hydra Cosmetics Inc. DuPont Analysis Value Correct/Incorrec Ratios Profitability ratios Value Correct/Incorrect Ratios Asset management ratio 50.00 Total assets turnover 20.92 1.43 Gross profit margin (%) Operating profit margin (%) Net profit margin (%) Return on equity 22.41 Financial ratios 53.52 Equity multiplier 1.67 (9%) LANDON: 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. Hydra Cosmetics Inc. DuPont Analysis Hydra Cosmetics Inc. DuPont Analysis Value Calculation Numerator Denominator Ratios Profitability ratios Gross profit margin (%) Operating profit margin (%) Net profit margin (%) Return on equity (%) Asset management ratio Total assets turnover Financial ratios Equity multiplier LANDON: I see what I did wrong in my computations. Thanks for reviewing these calculations with me. You saved me from a lot of embarrassment! Amelia would have been very disappointed in me if I had showed her 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. Use more equity financing in its capital structure, which will increase the equity multiplier. Increase the interest rate on its notes payable or long-term debt obligations because it will reduce the company's net profit margin. Reduce the company's operating expenses, its cost of goods sold, and/or the interest rate on its borrowed funds because this will increase the company's net profit margin. Increase the firm's bottom-line profitability for the same volume of sales, which will increase the company's net profit margin. LANDON: 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. 9. An analysis of company performance using DuPont analysis A sheaf of papers in his hand, your friend and colleague, Landon, steps into your office and asked the following LANDON: 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? LANDON: 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. Amelia, 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 Amelia 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 $700,000 Income Statement Data Sales $14,000,000 $840,000 Accounts payable Accruals 1,400,000 280,000 7,000,000 Accounts receivable Inventory Current assets 2,100,000 4,200,000 1,120,000 2,240,000 Cost of goods sold Gross profit Operating expenses EBIT Notes payable Current liabilities Long-term debt Total liabilities 7,000,000 3,500,000 3,640,000 3,500,000 5,880,000 571,200 Interest expense EBT 980,000 2,928,800 2,940,000 Taxes 732,200 Net fixed assets Common stock 5,600,000 Retained earnings Total equity $9,800,000 Total debt and equity 3,920,000 $9,800,000 Net income $2,196,600 Total assets If I remember correctly, the DuPont equation breaks down our ROE into three component ratios: t , the total asset turnover ratio, and the And, according to my understanding of the DuPont equation and its calculation of ROE, the three ratios provide insights into the company's effectiveness in using the company's assets, and Now, let's see your notes with your ratios, and then we can talk about possible strategies that will improve the ratios. I'm going to check the box to the side of your calculated value if your calculati is correct and leave it unchecked if your calculation is incorrect. Hydra Cosmetics Inc. DuPont Analysis Value Correct/Incorrec Ratios Profitability ratios Value Correct/Incorrect Ratios Asset management ratio 50.00 Total assets turnover 20.92 1.43 Gross profit margin (%) Operating profit margin (%) Net profit margin (%) Return on equity 22.41 Financial ratios 53.52 Equity multiplier 1.67 (9%) LANDON: 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. Hydra Cosmetics Inc. DuPont Analysis Hydra Cosmetics Inc. DuPont Analysis Value Calculation Numerator Denominator Ratios Profitability ratios Gross profit margin (%) Operating profit margin (%) Net profit margin (%) Return on equity (%) Asset management ratio Total assets turnover Financial ratios Equity multiplier LANDON: I see what I did wrong in my computations. Thanks for reviewing these calculations with me. You saved me from a lot of embarrassment! Amelia would have been very disappointed in me if I had showed her 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. Use more equity financing in its capital structure, which will increase the equity multiplier. Increase the interest rate on its notes payable or long-term debt obligations because it will reduce the company's net profit margin. Reduce the company's operating expenses, its cost of goods sold, and/or the interest rate on its borrowed funds because this will increase the company's net profit margin. Increase the firm's bottom-line profitability for the same volume of sales, which will increase the company's net profit margin. LANDON: 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