Computerized Investing - Spreadsheet Collection/Spreadsheet Collection.iso/pc/ibm9/dupont.doc

Text File | 1991-07-11 | 5.3 KB | 107 lines

DuPont Analysis
By John Bajkowski
Computerized Investing, January/February 1990

As a shareholder, the return a company is providing on your
funds (return on equity) is a key consideration in judging
the performance of the firm's managers. DuPont analysis
provides a framework to show how both the management of the
company's operation and its financial structure impacts
return on equity. DuPont analysis derives its name from the
DuPont corporation, which developed and began using this
approach in the early 1920s.

The DuPont analysis for Sara Lee uses data from the 1988 annual
report. The shaded boxes represent those in which data must be
entered. We have taken advantage of Microsoft Excel's ability to
draw the various boxes and lines, but if you are using Lotus 1-2-3
you must skip the boxes and use dashes, > and | characters to draw
the relationships between the various calculations and ratios.
When entering these and other characters that might be
interpreted as mathematical operations, you must precede the
symbol with a character to let the program know that you are
entering a label instead of a number. In Lotus 1-2-3, you
would use the, ', or " symbols to inform the program that you
are entering text, depending on if it should be centered,
aligned on the left side of the cell, or aligned on the right
side of the cell. In Excel, you would have to enclose the
item in double quotes and precede the statement with an
equals (=) sign.

The top portion of the worksheet deals primarily with the
income statement (good operations management), while the
bottom portion emphasizes the balance sheet (prudent use of
financial leverage). This separation highlights that return
on equity is affected by firm profitability and balance sheet
structure.

Sales, interest income (other income), cost of goods sold,
selling and administration expenses, interest expense, and
taxes are entered from the income statement to determine net
earnings (or net income on some financial statements). Net
earnings divided by sales gives us the profit margin. It
might be worth noting that Sara Lee did not break out
depreciation as a separate line item on its income statement,
so we left that cell blank. Data from the statement of cash
flows or even changes in accumulated depreciation can by used
to determine the depreciation, but for the purpose of DuPont
analysis it was not important to break the information out.
As you work with different companies, you will find slight
variations in how they present their financial statements.
The worksheet, with its other categories, should prove
flexible enough to deal with the variations or it can be
easily modified to conform to the variations.


Asset data from the balance sheet is entered to determine the
total assets. For Sara Lee, other assets include trademarks,
investments in unconsolidated companies and intangibles.
Dividing sales by total assets gives us asset turnover. Asset
turnover times profit margin provides the return on assets.

The liabilities from the balance sheet are entered to
determine the total debt. For Sara Lee, other current
liabilities consist of notes payable, current maturities of
long-term debt and current obligations under capital leases.
The other liabilities box includes long-term obligations
under capital leases, deferred income taxes and other
liabilities. Total debt divided by total assets provides the
financial leverage figure. Financial leverage refers to the
percentage of total assets financed through debt.

Dividing return on assets by one minus financial leverage
computes the return on equity. Examining the interplay
between the ratios is the key behind DuPont Analysis. Return
on equity can be increased through higher return on assets or
a higher degree of leverage--more debt relative to assets.
The high degree of financial leverage is how buyout artists
hope to make big profits when they take on huge amounts of
debt in acquiring companies. The risk in the strategy is that
the company will not generate enough cash flow to cover the
interest payments. Proper use of financial leverage can help
increase the return on equity. If Sara Lee had no debt its
return on equity would be the same as its return on as-
sets--6.48%.

Return on assets can be increased with higher profit margins
or higher asset turnover. Margins are improved by lowering
expenses relative to sales. Asset turnover can be improved by
selling more goods with a given level of assets. This is why
companies try to divest assets (operations) that do not
generate a high degree of sales relative to the value of the
assets, or assets that are decreasing their sales generation.
When examining profit margins or asset turnover, it is
important to consider industry trends and compare how a
company is doing within its industry. A supermarket chain,
for example, would tend to have low profit margins, but make
it up in high turnover.

DuPont analysis highlights the interaction between a
company's operation and its capital structure. It gives
investors a tool with which to judge the performance of
management on a few levels. lt also helps to remind investors
that ratios should not be examined in a vacuum, but studied
to see how they affect the overall organization.

(c) Copyright 1991 by the
American Association of Individual Investors