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DuPont Analysis Lecture Notes

Jamal Munshi, 1994


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Ratio analysis basics

Income Statement

• NOI = S*(1 - vc/s) - FC


• NIAT = (NOI - I)*(1-t)

Balance Sheet

• TA = D + E

Stmt of Cash Flows

• CFO = NIAT + Dep


• CFC = [NOI + Dep]/[I + DS/(1-t)]

Ratios to assess operating decisions

• PM = NOI/S
• TAU = S/TA
• ROI = NOI/TA
• Note that ROI = PM * TAU

Ratios to assess financial decisions

• ROE = NIAT/E
• i = I/D
DuPont analysis equations

• ROI = PM * TAU (for operating decisions)


• ROE = (1-t)*[ROI + (D/E)*(ROI-i)] (for financial decisions)

DuPont analysis of operating decisions:

• ROI is partitioned into two multiplicative components - that which can be


ascribed to our ability to control costs and that affected by our ability to use
assets to generate sales. It is an analytical tool and not a computational tool.

DuPont analysis of financial decisions:

• ROE is partitioned into two additive components - that which can be ascribed to
operations and an additional component due to financial leverage. It is an
analytical tool and not a computational tool.
Definitions

• Income Stmt = matches costs to revenue in corresponding time periods.



• Balance sheet = Distribution of claims on assets.

• Cash flows = actual funds flowing to and from our checking account.

• PM [profit margin] = our ability to control costs = measured by the amount of
operating income per dollar of sales.

• TAU [total asset utilization ratio] = our ability to use assets to generate sales =
measured by the amount of sales generated per dollar of assets.

• ROI [return on assets] = bottom line of our operations that assesses whether it
is a good business to be in = the amount of operating income generated per dollar
of assets.

• i [little eye] = net cost of borrowed funds = measured as a percentage.

• ROE [return on equity] = the bottom line of the business enterprise that
measures our ability to increase the wealth of the owners = measured as the
amount of net income made available to our shareholders per dollar of their
investment.


• DOL [degree of operating leverage] = the sensitivity of operating income to
fluctuations in sales = the percentage change in NOI caused by a one percent
change in sales = a measure of risk inherent in our operations = caused by fixed
costs in our cost structure.

• DFL[degree of financial leverage] = the sensitivity of net income to fluctuations
in operating income = the percentage change in NIAT caused by a one percent
change in NOI = additional risk induced by the use of borrowed funds = caused
by fixed financial charges due to our capital structure.

• FFL [favorable financial leverage] = when ROI is greater than i debt can be used
to leverage (increase) ROE beyond ROI*(1-t).
• Indifference point: ROI=i
• UFL [unfavorable financial leverage], ROI is less than i, increased use of debt
(cp) decreases ROE
Development of working equations

• DOL = [dNOI/NOI]/[dS/S]
• = [dNOI/dS] * [S/NOI]
• = (1-vc/s)*S/NOI
• = (NOI+FC)/NOI

• DFL = [dNIAT/NIAT]/[dNOI/NOI]
• = [dNIAT/dNOI]*[NOI/NIAT]
• = (1-t)*NOI/NIAT
• = [(1-t)*NOI]/[(1-t)*(NOI-I)]
• = NOI/(NOI-I)

• ROI = NOI/TA
• = (NOI/S)*(S/TA)
• = PM*TAU

• ROE = NIAT/E
• = (1-t)*(NOI-I)/E
• = (1-t)*(ROI*TA - I)/E
• = (1-t)*(ROI*(D+E) - I)/E
• = (1-t)*(ROI*D + ROI*E - I)/E
• = (1-t)*(ROI*D + ROI*E - i*D)/E
• = (1-t)*(ROI*D/E + ROI*E/E - i*D/E)
• = (1-t)*[ROI + (D/E)*(ROI-i)]