Overview of Financial Statements Using the Dupont Analysis Approach


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Overview of Financial Statements Using the Dupont Analysis Approach

Providing Students with an Overview of Financial Statements Using the Dupont Analysis Approach
Dr. Gene Milbourn, University of Baltimore, Maryland
Dr. Tim Haight, California State
University, Los Angeles, CA
ABSTRACT
This paper uses the Dupont Analysis as a teaching
aid to equip students with
an understanding of how
management decisions influence the bottom line. This simplified approach allows students to see the “big picture”
and to logically follow how management decisions affect components that contribute to firm’s performance. As such
it can be a valuable tool in building a student’s critical th
inking competencies in evalua
ting the health, prospects and
valuations of companies.
INTRODUCTION
The volume of information contained in the balance sheet and income statement often overwhelms students
in an introductory finance class. Wh
ile basic accounting classes prepare studen
ts in the preparation of financial
statements, finance classes typically focu
s on their interpretation to aid in d
ecision-making. Unfo
rtunately, entering
students are often lost in the detail and are unable to see the forest for the trees.
The ultimate goal is for students to understand the interrelationships between financial statements and how
management decisions affect firm’s performance. To be sure, our future managers must fully understand the
financial consequences of all the decisions an
d how these decisions affect the bottom line.
Fortunately, there is a very powerful financial tool to assist students in understanding the ramifications of
decisions on profitability. The
Dupont Analysis
is a measurement instrument that can provide students with several
insights into key factors that contribute to bottom line perfo
rmance. This tool is used to evaluate a firm’s financial
condition by comparing relationships within the income statement and balance sheet, or between the two statements.
The
Dupont Analysis
provides information on the firm’s liquidity, profitability, efficiency, and leverage
status, thus allowing students to see how well a firm is operating as a result of changes in one or more of these
factors. It is a very powerf
ul tool that allows one to trace the financia
l impact of decisions
and to understand the
interrelationship between the income statement, balance sheet and firm profitability
RETURN ON ASSETS: THE
OPERATING INCOME VIEW
Dupont analysis begins by using the firm’s return on assets (ROA). Return measures can either be on a
before-tax or an after-tax basis. Here, we will illustrate
return using ROA, an after tax measure which is defined as
follows:
ROA =
Net Income After Taxes (NIAT)
{equation 1}
Assets (invested capital)
ROA measures the firm’s profits as a percent of its asse
ts. Note that ROA increases if any one of the three
following factors changes while the other two remain the same:
if costs decrease, income
increases, so ROA increases;
if revenue increases, income
increases, so ROA increases;
if assets decrease, ROA increases.
Students can quickly gain an understanding of how any of these changes affect return. To provide a context
for classroom discussion, the instructor will evaluate a firm’s performance, ROA with either an industry average or
the firm’s historic returns. If the firm has higher ROA than
the industry, the firm is more profitable. Similarly, if the
firm’s ROA is lower than the industry’s it is viewed as less profitable.
The Journal of American Academy of Business, Cambridge * March 2005
46
DUPONT ANALYSIS: BREAKING RO
A DOWN INTO TWO ELEMENTS
In Dupont analysis, the ROA is expanded and broken down into two components:
ROA = NIAT/ Revenue
X
Revenue/Assets {equation #2}
Where:
Revenue/Assets = Asset turnover (meas
ure of resource efficiency)
and
NIAT/Revenue = Net Profit Margin (pro
fits related to sales generated)
Thus, Dupont analysis translates the basic ROA ratio into the following:
ROA = Asset Turnover x Net Profit Margin {equation 2}
These two sub-measures are useful in the following way:
Asset turnover measures the efficiency of the firm’s asse
ts. The higher this ratio, the more efficient the assets.
Operating profit margin is an
indicator of the firm’s profitability as it relates to revenue.
These two measures, when combined, permit students to
see the relative contributio
ns of asset efficiency
and profitability on the firm’s Return on Assets.
The use of the Dupont System to investigate firm performance can employed on a time series basis or as
part of a cross sectional analysis within a given indust
ry or sector. Typically, a fi
rm can isolate the causes of
deteriorating ROA over time by separating the relative imp
act of its asset turnover and profit margin during the
period under investigation. Once the source of the deterior
ating ROA is isolated, firms can then focus on the area
suggested by the Dupont System. Often changes in firm’s
performance are a result of ex
ternal factors that may be
affecting the entire industry and/or sector within the indu
stry. Here, cross sectional an
alysis can be employed to
ascertain whether performance problems are isolated within the firm or are being experienced by competitors as
well.
ILLUSTRATION
The analysis below will investigate the relative firm performance of two firms within a hypothetical
industry. The Dupont Analysis is illustrated using the income statements and balance sheet statements of firms A
and B in Table 1 and Table 2. For this illustration we
will assume that accounting tr
eatment of such items, as
depreciation and inventory valuation are consistent. Each firm is examined on the basis of ROA and compared to its
industry norm in Table 3. The Dupont analysis is then us
ed to examine the relative cont
ributions of the efficiency
and profitability components to each firm’s ROA to understand in greater depth
the key factors affecting the firm’s
performance.
Table 1 Firms A and B: Income Statements
A
B
Sales
$550,000
$600,000
Cost of Goods Sold
305,000
400,000
Gross profits
$245,000
$200,000
General & Administrative
110,000
95,000
Net Operating Income
$135,000
$105,000
Interest expense
7,500
10,000
Earnings before taxes
$127,500
$95,000
Taxes (40%)
51,000
38,000
Net Income After Taxes (NIAT)
$ 76,500
$ 57,000
*Analysis assumes a 40% marginal tax rate
The Journal of American Academy of Business, Cambridge * March 2005
47

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