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, Ive got a meeting in an hour, but I dont want to start something new and then be interrupted by the meeting, so how can I help?

CHLOE: Ive been reviewing the companys financial statements and looking for general ways to improve our performance, in general, and the companys return on equity, or ROE, in particular. Eric, my new team leader, suggested that I start by using a DuPont analysis, and Id like to run my numbers and conclusions by you, to see if Ive 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

Income Statement Data

Cash$1,000,000Accounts payable$1,200,000Sales$20,000,000Accounts receivable2,000,000Accruals400,000Cost of goods sold12,000,000Inventory3,000,000Notes payable1,600,000Gross profit$8,000,000Current assets$6,000,000Current liabilities$3,200,000Operating expenses5,000,000Long-term debt4,500,000EBIT$3,000,000Total liabilities$7,700,000Interest expense732,000Common stock1,575,000EBT$2,268,000Net fixed assets8,000,000Retained earnings4,725,000Taxes793,800Total equity$6,300,000Net income$1,474,200Total assets$14,000,000Total debt and equity$14,000,000

If I remember correctly, the DuPont equation breaks down our ROE into three component ratios: the , 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 companys , effectiveness in using the companys assets, and .

Now, lets 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 Im going to select correct if your calculation is correct and incorrect if your calculation is incorrect.

Hydra Cosmetics Inc. DuPont Analysis

RatiosValueCorrect/IncorrectRatiosValueCorrect/IncorrectProfitability ratiosAsset management ratioGross profit margin (%)40.00 Total asset turnover1.43 Operating profit margin (%)11.34 Net profit margin (%)10.53 Financial ratiosReturn on equity (%)27.38 Equity multiplier1.82

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

YOU: Ive 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.

Hydra Cosmetics Inc. DuPont Analysis

Calculation ValueProfitability ratiosNumeratorDenominatorGross profit margin (%)

/

=

Operating profit margin (%)

/

=

Net profit margin (%)

/

=

Return on equity (%)

/

=

Asset management ratioTotal asset turnover

/

=

Financing ratiosEquity multiplier

/

=

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 lets switch topics and identify general strategies that could be used to positively affect Hydras ROE.

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

Check all that apply.

Decrease the amount of debt financing used by the company, which will decrease the total asset turnover ratio.

Increase the efficiency of its assets so that it generates more sales with each dollar of asset investment and increases the companys total asset turnover.

Increase the firms bottom-line profitability for the same volume of sales, which will increase the companys net profit margin.

Increase the interest rate on its notes payable or long-term debt obligations because it will reduce the companys net profit margin.

CHLOE: 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.