DuPont Financial Analysis Model

A Process For Knowing Where to Spend My Management Time

Tomorrow Morning After Breakfast
By
Kevin Bernhardt, UW!"tension, UWP#attevi##e, and
UW $enter for %airy Profita&i#ity
Our computer technology today provides wonderful opportunities to collect, manipulate,
and process data including financial analysis data. Sure, it gives a manager lots of
numbers, but what do they mean in terms of where to spend my creative management
time tomorrow morning after breakfast?
There is no lack of ratios to calculate from financial data, each of which is a valuable
piece of information to the manager. The Farm Financial Standard Councils sweet !"
ratios #recently e$panded% have been a standard for years in helping farm managers
evaluate their financials. &owever over several years of teaching undergraduate
students and '$tension clientele ( often found it difficult for people to wrap their arms
around what the ratios were indicating and ultimately where to spend their valuable
management time. The challenge often led to indifference by the undergraduate
students and a lack of seeing any value to go further by '$tension clientele.
The )u*ont system for financial analysis is a means to fairly +uickly and easily assess
where the business strengths and weaknesses potentially lie and thus where
management time may optimally be spent. (t is not the only nor the most thorough, but
it is a fairly straight,forward and systematic means to drill back into the financial
numbers to determine the source or lack thereof for financial performance.
- colleague, .regg &adley #/0,1iver Falls%, summed up well the )u*ont system in a
recent article on ','$tension #The )u*ont -nalysis2 3aking 4enchmarking 'asier and
3ore 3eaningful, /pdated 5une !6, 7668,
http299www.e$tension.org9pages9The:)u*ont:-nalysis2:3aking:4enchmarking:'asier
:and:3ore:3eaningful%2
If we are lucky enough to have the minimum number of financial
documents needed to conduct a meaningful financial analysis (both
beginning and ending balance sheets, either an actual accrual or accrual
adjusted income statement, and a statement of cash flows), we are then
inundated with pages and pages of intimidating numbers to sort through.
This gives many managers and advisers a justification not to give their
financial records anything more than a passing glance. This is
unfortunate. A good financial performance analysis should do more than
inform about how a farm performed in the past. ore important, it should
provide the manager and adviser with insight regarding how to prioriti!e
activities that will enable the farm to improve its financial performance.
The )u*ont system has disadvantages as does any financial analysis system.
&owever, its advantage beyond simplicity of use is that it takes into account the ma;or
levers of firm profitability < efficiency, asset use, and debt leverage.
-natomy of *rofits
4efore describing the )u*ont system, consider the anatomy of profits. The accounting
e+uation is2
Total -ssets = Total )ebt > Total Owner '+uity
-s the accounting e+uation shows every penny of assets comes from one of two
sources < that financed by debt #borrowed capital% and that financed by e+uity #the
owners own money%. -ssets can also be described by those that are capital assets
versus short,term inventory or market assets. Capital assets are longer,term
investments #land, machinery, breeding stock, etc.% that are not sold themselves to
make profits, but are put to work to produce marketable inventory that can be sold for
profits #feeder cattle, eggs, etc.%. (nventory also includes inputs such as feed, seed, and
fertili?er.
4usinesses earn profits by mi$ing their labor and management with inputs and capital
assets to produce goods for sale. The )u*ont system recogni?es this recipe for profit,
making and segregates it into three distinct components or levers2
!. 'arnings #or efficiency%,
7. Turnings #effective use of assets%, and
@. Aeverage #using debt to multiply earnings and e+uity%
(n the )u*ont system one can drill back into these three levers to determine where
profit performance is coming from and potentially determine where management time
should be spent for improving profits. Specifically )u*ont measures2
1. How efficiently inputs are being used to generate profits [Earnings]
2. How well capital assets are being used to generate gross revenues [Turnings]
3. How well the business is leveraging its debt capital [Leverage]
Figure ! shows a graphic of the )u*ont system. (t begins on the far right side with 1ate
of 1eturn on '+uity #1O1O'%. &igh 1O1O' is the pri?e in the )u*ont system.
1O1O' is calculated as2
Bet (ncome from Operations < /npaid Aabor C 3anagement
Total Owner '+uity
The financial manager can then drill backward to see where 1O1O' performance
either is, or is not, coming from.
Fig're () %'Pont System
*perating
Profit Margin
Asset T'rnover
+et'rn *n
Assets ,less
interest adj.)
Financia#
Str'ct're
+et'rn *n
!-'ity
. /
. /
!arnings
T'rnings
0everage
Starting on the upper side 1O1O', in,part, comes from how well the business is
earning profits from its assets as measured by the 1ate of 1eturn on -ssets #1O1O-%.
1O1O- is calculated as2
DBet (ncome from Operations > (nterest < /npaid Aabor and 3anagement
Total -ssets
(t makes sense that the higher the 1O1O- the higher the 1O1O'. (n,turn, the 1O1O-
comes from two components or levers of profitability.
One is how efficient the manager is in turning inputs into outputs, or in a financial sense,
how efficient the manager is in turning the gross revenue of dollars coming into the
business into net profits that are kept in the business after all e$penses are paid. This
is the E'arningsF lever and is measured by the Operating *rofit 3argin 1atio #O*31%.
The calculation is2
DBet (ncome from Operations > (nterest < /npaid Aabor and 3anagement
.ross 1evenue
(nterest is added back so that the measure you get is one that measures efficiency of
operations regardless of the debt structure. )ebt structure effects will come into the
system later. (n situations where there is unpaid labor and management it is deducted
to recogni?e the value of the labor and management. The more efficient you are in
turning gross sales into profits that you keep the higher your 1ate of 1eturn on -ssets
and ultimately the higher your 1ate of 1eturn on '+uity.
The second source of 1O1O' is how well you are using the assets of the business.
This lever is referred to as ETurningsF meaning how well you are turning assets into
production and sales of product. To use an e$treme e$ample, if you had a @66 acre
farm #all tillable% that you left sit idle then your performance of turning assets into
production and sales of product would go way down. The EturningsF lever is measured
by the -sset Turnover 1atio #-TO%. The calculation is2
.ross 1evenue
Total -ssets
The better able you are to use the assets you have to produce and sell product the
higher the 1ate of 1eturn on -ssets will be and the higher the 1ate of 1eturn on '+uity.
The last lever is EAeverage,F which is also known as E'+uity 3ultiplierF. 4efore going
further with the e$planation of leverage, it is worth backing up a step and e$ploring the
accounting e+uation again
#Total -ssets = Total )ebt > Total '+uity%.
.iven this e+uation, which is true for every business, then any profitable return to the
use of assets is a profit return to the assets financed by debt and to those financed by
e+uity. '+uity is fairly straight,forward, if you invest G!66 of your own money and earn
G!6 back then your e+uity has returned !6H #!69!66%. For the return to debt it is a bit
more complicated because you have to pay someone for the use of the debt < interest.
So, the +uestion becomes whether or not the debt you have is returning a profit larger
than the interest you have to pay for using that debt. (f it is then the leftover profit after
paying interest is an additional return to your e+uity. That is, if (m paying IH interest
and my profit return on the debt is !6H, then ( not only can pay my interest, but ( have
7H leftover that ( get to keep. This 7H becomes and increase to my e+uity. This is why
the debt or leverage component of )u*ont is sometimes called an E'+uity 3ultiplier.F
(t may seem an odd statement to make for some, but if you want to increase your
1O1O' then one way to do it is to increase your debtJ The trick is that the debt must
be managed in a way that returns a profit greater than the interest rate. (f it is not then
the e+uity multiplier still works, ;ust in the wrong directionJ
/ltimately the leverage lever is measured by the )ebt to -sset ratio #)2-%, which is
calculated as2
Total )ebt
Total -ssets
For ease of the math in the model, the leverage lever can be e$pressed as2
Total -ssets
Total '+uity
The greater this ratio then the more the proportion of debt is in the mi$ of assets. (f the
assets financed by debt are earning a return greater than the interest rate, then the
higher the ratio the greater the 1ate of 1eturn on '+uity.
Figure 7 shows the same )u*ont model with the ratio measures.
1et 2ncome from *perations3 2nterest 'npaid #a&or 4 mgt
5ross+even'e
5ross+even'e
Tota# Assets
+*+*A ,less
interest adj.)
Tota# Assets
Tota# !-'ity
+*+*!
. /
. /
!arnings
T'rnings
0everage
*PM+
AT*
Figure 72 )u*ont 1atios
Bote, the interest rate ad;ustment in the 1O1O- bo$ is the ad;ustment needed to return
the cost of interest before measuring the 1ate of 1eturn on '+uity. 1ecall that interest
was taken out when calculating the O*31.
The )u*ont system as illustrated allows you to identify where profit performance is, or
is not, coming from in one or more of three areas. Once identified then the ne$t step is
to drill back into the numbers that make up the ratio of concern.
For e$ample, if the O*31 is found to be lower than the manager would like it to be then
look at the numerator of the O*31 #net income from operations > interest < unpaid
labor C mgt% to determine what might be the problem, particularly e$penses. Compared
to your more profitable peers what are your labor, vet, repair, and other input costs?
(f the performance problem appears to be coming from a low -TO then the manager
might drill back into the business assets to see how well they are being used. -re there
dead assets in the business #ones not being used to create product for sales%, does the
business have e$cess machinery capacity, or are there assets that are under productive
#poor weight gain, breeding cycles too long, sickness, death loss, etc.%.
(f the debt structure is low, that is debt is not leveraging e+uity as much as peer
businesses, then the manager might drill back and +uestion how debt is being used.
Could additional debt be used to improve facilities, machinery, etc. that ultimately pays
for itself in higher production and sales or does debt that is not productive need to be
paid off #or perhaps the assets sold%.
-s with all financial analysis systems the model is only as good as the numbers that go
into it, that is, garbage in then garbage out. -nother valuable piece of information to
have to evaluate )u*ont is benchmarks of profitable peers. There are general ranges
for each of the ratios, but each industry and your si?e within an industry makes a
difference as to what is EgoodF for the ratios. Finally whether you rent or own the assets
you use in a business also makes a difference in the interpretation of the ratios.
-ppendi$ - provides a brief e$ample of using the )u*ont model.
(t is often said that management is part science and part art. The )u*ont system has
both elements. The ratio calculations are science and ;ust a manipulation of numbers.
The art is interpreting the ratios and drilling back into where the ratios indicate there
could be challenges and thus information of where to spend your creative management
time tomorrow morning after breakfast.
Appendi" A
4rief '$ample #-dapted from an e$ample from Te$as Tech /niversity%
http!!www.aaec.ttu.edu!faculty!phi"ohns!##E$%2&'31(!Lecture!notes!)*+,-T.ht.
Table 1. )u+ont #nalysis for Two /ar.s
/ar.er # /ar.er 0
1. ,perating profit .argin ratio 1,+234 &.3& &.12
2. #sset turnover ratio 1#T,4 &.2& &.3(
3. 3,3,# 11524 &.&(& &.&'3
'. 6nterest e7pense to avg. far. assets &.&8 &.&3
8. E9uity .ultiplier 2.&& 1.8&
(. 3,3,E 13:'4 5 8 &.&2 &.&2
/ar.er # and /ar.er 0 each have a 2 % 3,3,E. However; the levers of the )u+ont syste.
indicate that the sources of the wea<ness are different. /ar.er # has a stronger operating profit
.argin ratio but lower asset turnover co.pared to /ar.er 0. /urther.ore; /ar.er # has a
higher leverage ratio 1e9uity .ultiplier4 than /ar.er 0.
The wea< ratios for each far. .ay be deco.posed into co.ponents to deter.ine the potential
sources of the wea<ness. To i.prove asset turnover /ar.er # needs to increase production
efficiency or price levels or reduce current or noncurrent assets. To i.prove profit .argins;
/ar.er 0 needs to increase production efficiency or price levels .ore than costs or reduce costs
.ore than revenue.
The )u+ont analysis is an e7cellent .ethod to deter.ine the strengths and wea<nesses of a far..
# low or declining 3,3,E is a signal that there .ay be a wea<ness. However; using the )u+ont
analysis can better deter.ine the source of wea<ness. #sset .anage.ent; e7pense control;
production efficiency or .ar<eting could be potential sources of wea<ness within the far..
E7pressing the individual co.ponents rather than interpreting 3,3,E itself .ay identify these
wea<nesses .ore readily.