An analysis of company performance using DuPont analysis

Walking down the hall of your office building with a sheaf of papers in his hand, your friend and colleague, Akira, stepped into your office and asked the following.

AKIRA: 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?

AKIRA: 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. Emma, 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 Emma 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	$700,000	Accounts payable	$840,000	Sales	$14,000,000
Accounts receivable	1,400,000	Accruals	280,000	Cost of goods sold	7,000,000
Inventory	2,100,000	Notes payable	1,120,000	Gross profit	7,000,000
Current assets	4,200,000	Current liabilities	2,240,000	Operating expenses	3,500,000
		Long-term debt	3,150,000	EBIT	3,500,000
		Total liabilities	5,390,000	Interest expense	512,400
		Common stock	1,102,500	EBT	2,987,600
Net fixed assets	5,600,000	Retained earnings	3,307,500	Taxes	1,045,660
		Total equity	4,410,000	Net income	$1,941,940
Total assets	$9,800,000	Total debt and equity	$9,800,000

If I remember correctly, the DuPont equation breaks down our return on equity (ROE) into three component ratios: the (Gross profit margin/net profit margin). The (fix asset turnover/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 companys (use of debt versus equity financing/management of its sales and share price), effectiveness in using the companys assets, and (management of its liquidity and its tax records/control over its expenses).

Now, lets see your notes with your ratios, and then we can talk about possible strategies that will improve the ratios.

In the following table, select whether each of the ratios is correct or incorrect.

Pavo Media Systems Inc.DuPont Analysis
Ratios	Value	Correct/Incorrect	Ratios	Value	Correct/Incorrect
Profitability ratios			Asset management ratio
Gross profit margin (%)	50.00	?	Total assets turnover	1.43	?
Operating profit margin (%)	21.34	?
Net profit margin (%)	19.82	?	Financial ratios
Return on equity (%)	51.58	?	Equity multiplier	1.82	?

AKIRA: 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 for this part.

Pavo Media Systems Inc.DuPont Analysis		Calculation
Ratios	Numerator		Denominator		Value
Profitability Ratios
Gross profit margin (%)	?	/	?	=	?
Operating profit margin (%)	?	/	?	=	?
Net profit margin (%)	?	/	?	=	?
Return on equity (%)	?	/	?	=	?

		Calculation			Value
	Numerator		Denominator
Asset management ratio
Total assets turnover	?	/	?	=	?

Financial ratios		Calculation			Value
	Numerator		Denominator
Equity multiplier	?	/	?	=	?

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

So, now lets switch topics and identify general strategies that could be used to positively affect Pavos 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.

Reduce the companys operating expenses, its cost of goods sold, and/or the interest rate on its borrowed funds because this will increase the companys net profit margin.

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

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

Decrease the companys use of debt capital because it will decrease the equity multiplier.

AKIRA: 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.