DuPont System For Financial Analysis

1. DuPont System For Financial Analysis By Kevin Bernhardt, UW-Platteville and UW-ExtensionMarch 10, 2010 http://cdp.wisc.edu/Management.htm

2. First,This Thing Called Debt

3. Anatomy of Returns Total Assets = Total Liabilities + Total Equity Total amount of stuff used in the business to make profits (supplies, inputs breeding stock, machinery, etc.) How much of that stuff is financed by the “bank”, that is, debt capital. How much of that stuff is financed by your own money, that is, equity capital. So, when you make profits, those profits are a return to all the assets, some of which is a return to your money invested (equity capital) and some of which is a return to the bank’s money (debt capital).

4. Anatomy of Returns – Case 1 $1,000 of Total Assets (all financed by my own money) generated $500 of total revenue, $400 of total expenses, and thus $100 of profits. $10 cents of income per dollar of asset 1001000 = ROROA = 10% Since it is all my money, then ROROE = 10%

5. Anatomy of Returns – Case 2 $1,000 of Total Assets (financed $700 by my own money and $300 @8% borrowed from a bank) generated $500 of total revenue, $400 of expenses before interest for $100 profit, and $76 profits after interest expenses. I leveraged someone else’s money to increase the return to my money. ROROE = 10.9% $10.9 cents of income per dollar of your money 76700 My money(Equity Capital) = $700 Before interest $.10 cents of income per dollar of all assets used. 1001000 $1000 Total Assets = $300 ROROA = 10% Bank’s money(Debt capital) ROROA>i-rate The extra is payment to equity 10% 8% Thus 2% additional to Equity

6. Anatomy of Returns – Case 2 $1,000 of Total Assets (financed $700 by my own money and $300 @8% borrowed from a bank) generated $500 of total revenue, $400 of expenses before interest for $100 profit, and $76 profits after interest expenses.

7. Anatomy of Returns – Case 3 $1,000 of Total Assets (financed $700 by my own money and $300 @8% borrowed from a bank) generated $500 of total revenue, $500 of expenses before interest for $0 profit, and -$24 profits after interest expenses. ROROE = -3.4% -$3.4 cents of income per dollar of your money -24700 My money(Equity Capital) = $700 Before interest $0 cents of income per dollar of all assets used. 01000 $1000 Total Assets = $300 ROROA = 0% Bank’s money(Debt capital) Making 0% on all assets, but paying 8%, and the additional 8% is coming out of equity.

8. Anatomy of Returns – Case 3 $1,000 of Total Assets (financed $700 by my own money and $300 @8% borrowed from a bank) generated $500 of total revenue, $500 of expenses before interest for $0 profit, and -$24 profits after interest expenses.

9. Anatomy of Returns – Case 4 $1,000 of Total Assets (financed $700 by my own money and $300 @15% borrowed from a bank) generated $500 of total revenue, $400 of expenses before interest for $100 profit, and $55 profits after interest expenses. ROROE = 7.9% $7.9 cents of income per dollar of your money 55700 My money(Equity Capital) = $700 Before interest $.10 cents of income per dollar of all assets used. 1001000 $1000 Total Assets = $300 ROROA = 10% Bank’s money(Debt capital) Making 10% on all assets, but paying 15% on debt portion (ROROA<i-rate), and the difference must come from equity.

10. Anatomy of Returns – Case 4 $1,000 of Total Assets (financed $700 by my own money and $300 @15% borrowed from a bank) generated $500 of total revenue, $400 of expenses before interest for $100 profit, and $55 profits after interest expenses.

11. So, How Is Money Made? • Through Three Primary Levers • By being efficient with your operations • By getting the most out of your assets • By leveraging your money • that is, helping your own money do bigger and better things through borrowed use of someone else’s money.

12. So, How Can I Analyze How I am Doing At Making Money, Or better yet how I might make more money? • By analyzing each of the three levers that leads to Return on Equity – ROROE: • Efficiency of operations • How well assets are working into profits • Leverage

13. Introducing the DuPont System for Financial Analysis DuPont

14. DuPont System • Developed in 1919 by a finance executive at E.I. du Pont de Nemours and Co • “The DuPont system is a way of visualizing the information so that everyone can see it.” (Stephen Jablonsky, Penn State University) • DuPont analysis “is a good tool for getting people started in understanding how they can have an impact on results” (Doug McCallen, Caterpillar Inc.) • “Number one, it’s simple” (Sam Siegel, CFO)

15. DuPont System • “DuPont Financial Analysis Model is a rather straightforward method for assessing the factors that influence a firm’s financial performance.” (Gunderson, Detre, and Boehlje, AgriMarketing 2005)

16. DuPont System – What is It? • The system identifies profitability as being impacted by three different levers: • Earnings & efficiency in earnings • Ability of your assets to be turned into profits • Financial leverage Earnings Turnings Leverage

17. DuPont System Earnings/Efficiency Operating Profit Margin Return On Assets (less interest adj.) IncomeStream = X Asset Turnover Return On Equity = X Turnings/Asset Use Financial Structure InvestmentStream Leverage

18. DuPont System Ratios Earnings OPMR Operating Profit Margin ROROA Return On Assets (less interest adj.) IncomeStream = X ROROE Asset Turnover ATO Return On Equity = X Turnings Total Assets/Total EquityDerived from the Debt To Asset Ratio (D:A) Financial Structure InvestmentStream Leverage

19. Let’s Do The Math

20. DuPont System Earnings/Efficiency Operating Profit Margin Return On Assets (less interest adj.) = X Asset Turnover Return On Equity = X Turnings/Asset Use Financial Structure Leverage

21. Rate Of Return On Assets NFIFO + interest paid - unpaid labor/mgt ROROA = Total Assets Operating Profit Margin Ratio Asset Turnover Ratio Total Revenue Total Assets NFIFO + interest pd – unpaid labor/mgt Total Revenue X

22. DuPont System Earnings/Efficiency Operating Profit Margin Return On Assets (less interest adj.) = X Asset Turnover Return On Equity = X Turnings/Asset Use Financial Structure Leverage

23. Rate Of Return On Equity NFIFO – unpaid labor/mgtROROE = Total Equity i-rate Adj. Rate Of Return On Assets NFIFO + interest pd. – unpaid labor/mgt Total Assets interest pd.Total Assets - Leverage Ratio NFIFO – unpaid labor/mgt Total Assets = X Total Assets Total Equity

24. Net Farm Income From Operations (NFIFO) NFIFO = Total Revenue – Basic Costs – Non Basic Costs sales, govt. pmts, custom work +(-) inventory changes labor + depreciation + interest expenses cash expenses +(-) accrual expense changes NFIFO = Total Revenue – COGS – Operating Expenses – Interest

25. Leverage is the mix of debt versus equity capital used in making profits. - Do we have too much debt?- Do we have enough debt?- Is our debt capital generating profits?- Can our debt capital be put to better use? Return On Assets OK Return On Equity = X Too Low Total AssetsTotal Equity Too Low Leverage

26. OK Total Revenue = cash income +(-) inventory changes Basic Costs = cash expenses +(-) accrual exp changes + purch lstk Depr Non Basic Costs = labor + depreciation + interest expenses Too Low NFIFO – unpaid labor/mgt + interestTotal Revenue OPMR Earnings Return On Assets Too Low = X Total RevenueTotal Assets Turnings OK ATO • Too much labor given output- Not enough labor • Training and Education • Better systems and processes- Weekly/Daily staff meetings • Performance metrics Return On Equity = X Too Low Total AssetsTotal Equity OK Leverage

27. OK NFIFO – unpaid labor/mgt + interestTotal Revenue OPMR Earnings Return On Assets Too Low = X Total RevenueTotal Assets Turnings Too Low ATO • Unproductive machinery? - Buildings not being used? - Breeding livestock not producing? - Unproductive land?- Over valued assets? Return On Equity = X Too Low Also, selling off unproductive assets and paying off debt could change your leverage position in a positive way, and also improve your ROROE! Total AssetsTotal Equity OK Leverage

28. Financial Diagnostics via DuPont. Finding the Red Flags! PricesProductionQualityFacilitiesProcessesOperationsHealthLaborRepairsTimelinessManagement Revenues too low for costs OPM too Low Costs too high for Revenues ROROA too Low ATO too Low Obsolete or Inefficient Assets ROROE too Low Wrong Kind of Debt Ability to Manage Assets Leverage Unused or Under Utilized Assets Not Enough Debt

29. End http://cdp.wisc.edu/Management.htm

31. Rate Of Return On Equity NFIFO – unpaid labor/mgtROROE = Total Equity Rate Of Return On Assets NFIFO – unpaid labor/mgt + interest pd.ROROA = Total Assets Operating Profit Margin Ratio NFIFO – unpaid labor/mgt + interest pd.OPMR = Total Revenue Asset Turnover Ratio Total RevenueATO = Total Assets Leverage Ratio Total AssetsFinancial Structure = Total Equity