Printer Friendly
The Free Library
23,383,293 articles and books


A better way to gauge profitability: systematic ratio analysis using the advanced DuPont model.

EXECUTIVE SUMMARY

* Return-on-equity (ROE) is the correct profit metric to evaluate the performance of a business. However, the primary emphasis on financial ratio analysis must be on operating performance.

* The "advanced" version of the DuPont model remedies the original model's failure to cleanly separate the effects of operating and financing decisions. It introduces the concept of return on net operating assets (RNOA) as the core measure of operating performance and clearly separates the effects of leverage and operating decisions.

* The advanced model does not change the result of the ROE calculation. However, the elements underlying the ROE ratio are different and provide a clean separation of operating and financing decisions.

* RNOA is effectively insulated from financing decisions. Changing the amount of debt does not affect the operating assets or the profit before interest expense and, therefore, does not affect RNOA. It also permits straightforward computation of the impact on ROE of alternative financing decisions. Changes in the interest rate affect the spread, while changes in the amount of debt affect financial leverage in a transparent manner.

**********

[ILLUSTRATION OMITTED]

Ratios provide a concise and systematic way to organize the enormous quantity of data contained in financial statements into a framework that creates meaningful information. Financial managers use ratios to benchmark their firm's performance against that of their competitors and set goals for future performance. Financial advisers use ratios to identify underpriced or overpriced stocks and make recommendations to investors.

Public accountants use ratios in nearly every service they offer to their clients. In the independent auditing arena, analytical procedures, which include ratio analysis, have effectively become a generally accepted auditing procedure since SAS 56 was issued in April 1988.

Return-on-equity (ROE) is the ratio most commonly used to analyze the profitability of a business. The "original" DuPont ROE model, which was created in 1919 by a finance executive at E.I. du Pont de Nemours & Co., breaks ROE into three fundamental drivers of accounting return-on-equity: net profit margin, asset utilization and financial leverage.

An "advanced" version of the DuPont model, which has found its way into accounting textbooks over the past several years, remedies the original model's failure to cleanly separate the effects of operating and financing decisions. It introduces the concept of return on net operating assets (RNOA) as the core measure of operating performance and clearly separates the effects of leverage and operating decisions.

This article demonstrates the benefits of the advanced DuPont model and uses the model to compare the financial performance of two popular U.S. retailers: Target and Costco.

THE ORIGINAL DUPONT MODEL OF FINANCIAL ANALYSIS

The original DuPont model can be illustrated with a simple example using two savings banks. Assume that Bank A and Bank B are, respectively, willing to pay 10% and 6% for deposits and are also willing to lend at the same rates. An all-equity firm with $1,000 in assets to invest would clearly choose Bank A to earn an ROE = Return on Assets (ROA) = 10%. Assume the firm pays out all profits in the form of a cash dividend.

Using the original DuPont model to examine the effects of financial leverage on ROE and ROA, assume a firm borrows $800 from Bank B at 6%, leaving an equity investment of $200. The reader can verify that:
Interest revenue = $100 Interest expense = $48
Net income (NI) = $52 Equity = $200
Assets = $1,000 ROE = $52/$200 = 26.0%


The model disaggregates ROE into two components: ROA (NI / Assets) and financial leverage (Assets / Equity).
ROE/ = [NI/Assets/ x [Assets/Equity/
26.0% 5.2%] 5.0]


This demonstrates the fundamental shortcoming of the original DuPont model. The decline in ROA from 10% to 5.2% could easily be interpreted as lower operating performance. However, in both examples, the firm's managers have invested all of the firm's assets in Bank A, still earning a 10% return. Therefore, many seasoned analysts feel that the decline in ROA is a false signal of a decline in the firm's operating performance.

The model's failure to insulate the ROA ratio from the effects of financing decisions is a major shortcoming in the model and prompted the development of a variation of the DuPont model. Here's another way of illustrating the significance of the problem: Consider an operating manager who is entrusted with $1,000 of assets and has been earning a 10% return on assets. The CFO then decides to finance some of the assets with debt instead of equity The ROA used to assess the operating manager's performance drops from 10% to 5.2%. In this case, the operating manager does not have control over capital structure decisions, yet his or her performance metric (ROA) is being affected by the financing decision.

Alternatively, a financial analyst or auditor using the model might fail to take into account the separate effects of operating and financing decisions on a firm's ROA and might reach erroneous conclusions about the relative operating performance of levered and un-levered firms.

Finally, an auditor applying the model might reach unwarranted conclusions about a client's operating performance if the capital structure changed over time. These simple examples illustrate the need for an ROE model that distinguishes between the effects of operating and financing decisions. The advanced DuPont model has been developed to meet that need.

THE ADVANCED DUPONT MODEL OF FINANCIAL ANALYSIS

The advanced DuPont model does not change the result of the ROE calculation. However, the elements underlying the ROE ratio are different. The following examples demonstrate how the advanced DuPont model allows for a clean separation of operating performance--return on net operating assets (RNOA)--and financing decisions--financial leverage (FLEV) and spread--and helps managers, analysts and CPAs avoid erroneous conclusions from their financial statement analyses.

Using the earlier set of facts to illustrate the use of the advanced DuPont model, net income is computed as follows:
Net = [Interest x Equity/ + Net Interest x Debt/ = Net
Income Rate/ $200 Rate/ $800 Income
 10%] (10%-6%) $52


Note that the $200 in equity earns 10% while the $800 in debt earns 4% net of the interest cost. ROE is defined as net income divided by equity, so dividing by $200 yields the following expression for ROE:
ROE = Interest x [Equity/ + Net Interest + [Debt/ = ROE/
 Rate/ Equity/ Rate/ Equity/ 26.0%
 10% $200/ (10%-6%) $800/
 $200] $200]


The notation of the advanced DuPont model yields the following expression:
ROE/ = RNOA/ + Spread/ x FLEV/
26.0% 10.0% 4.0% 4.0


RNOA = $100 / $1,000 = 10%

Spread = RNOA - Interest Rate = 10% - 6% = 4%

FLEV = Interest-Bearing Debt / Equity = $800 / $200 = 4.0

RNOA is the appropriate metric to assess management's operating decision to invest the assets in Bank A because it is effectively insulated from the financing decision. Changing the amount of debt does not affect the operating assets or the profit before interest expense and, therefore, does not affect RNOA. This remedies one of the primary problems with the original DuPont model. It also permits straightforward computation of the impact on ROE of alternative financing decisions. For example, changes in the interest rate affect the spread while changes in the amount of debt affect financial leverage in a transparent manner.

APPLICATION

We now apply the advanced DuPont model to analyze the discount retailers Target Corp. and Costco Wholesale Corp. Yahoo! Finance provides financial statements in a standardized format facilitating our analysis. See Exhibit 1 for the balance sheets and income statements for both firms in GAAP format. (Target officials reviewed this article. A Costco investor relations official could not be reached.)

Note that in our example, we include Target's credit card revenues/expenses and Costco's membership fees in the analysis. (Yahoo! Finance provides only the total revenue number.) Some financial analysts would exclude these items to get a better picture of operating performance. Both firms have nonsales related revenue of approximately equal magnitude, so including the figures should not affect the comparison in a significant way.

First, we calculate ROE from the financial statements in GAAP format using average stockholder equity in our calculation, because the net income was earned evenly throughout the year and the investment by owners, therefore, changed evenly throughout the year. The same rationale is applied for all balance sheet items. The averages of beginning and ending balances are used in the subsequent analyses. It is worthwhile to note that both companies have highly seasonal revenues and inventories. Using average inventory levels based on beginning and ending fiscal year values (when such levels are unusually low), therefore, understates the true average investment in inventories (operating assets) throughout the year.
Target ROE/ = NI/ / Equity/
Costco 18.7%/ 2,787.0/ 14,919.0/
 12.2% 1,083.0 8,884.0


Next, we reformulate the financial statements to distinguish between operating and financing activities (see Exhibit 2). Note that the balance sheet calculates operating assets, operating liabilities (the difference between these two is net operating assets), financial assets (Target does not report any financial assets in the form of investments in marketable securities), and financial liabilities (interest-bearing debt).

The difference between financial assets and financial liabilities is net financial obligations. Also, a firm with financial assets greater than financial liabilities would effectively have negative financial liabilities (financial assets) and negative interest expense (interest income).

Similarly, the income statement calculates net operating profit after tax (NOPAT) and then subtracts after-tax interest to arrive at net income, which is the same as in the GAAP format.

We are now ready to apply the advanced DuPont model formulation to Target and Costco. From Exhibit 2, we reproduce the income statement and balance sheet items shown in Exhibit 3 (all Target and Costco financial statement numbers are in millions and balance sheet numbers are averages of values for the beginning and end of the year):
Exhibit 3 DuPont Model Earnings

Target
(in millions)

Balance Sheet Income Statement

NOA NFO Revenue $59,490
 $9,955 Operating Expenses 54,421
 Operating Income 5,069
$24,874 SE Income Taxes 1,928
 $14,919 NOPAT 3,141
 NFE 354
 Net Income 2,787

Costco
(in millions)

Balance Sheet Income Statement

NOA NFO Revenue $64,400
 $445 Operating Expenses 62,626
 Operating Income 1,774
$9,329 SE Income Taxes 650
 $8,884 NOPAT 1,124
 NFE 41
 Net Income 1,083

NOA = net operating assets
NFO = net financial obligations
SE = stockholders equity
NOPAT = net operating profit after taxes
NFE = net financial expense (after tax)


These variables are combined to verify that the advanced DuPont model calculates the same ROE as in the original DuPont model using the GAAP formulation of the financial statements.
 ROE/ RNOA/ + Spread/ x FLEV/
Target 18.7%/ = 12.62%/ 9.07%/ 0.667/
Costco 12.2% 12.01% 2.93% 0.050


RNOA = NOPAT / NOA

NBC = net borrowing cost = NFE / NFO

SPREAD = RNOA - NBC

FLEV = NFO / SE

Both firms have virtually identical operating performance (RNOA). Target's higher ROE is almost entirely a result of financing effects. The firm uses more financial leverage and has a higher spread, which makes ROE almost 50% greater than without financial leverage (Target's credit card business helps explain a portion of the financial leverage difference).

We now understand how operating performance and non-operating performance combine to create return on equity. To gain a better understanding of operating performance, we can disaggregate it into profit margin and asset turnover components. This is accomplished in the following manner (note the algebraic identity because revenue (REV) cancels out):

NOPM = net operating profit margin

NOAT = net operating asset turnover

[ILLUSTRATION OMITTED]

Target achieves its operating performance with higher profit margins but lower operating asset turnover. How do we know this is strategy and not happenstance? Firms that choose a cost leadership strategy will typically sell at lower prices but with higher volume, while firms that choose a differentiation strategy will sell smaller quantities but at higher prices. Looking at NOPM and NOAT for six firms in the discount variety store industry--Target, Costco, Dollar General Corp., Wal-Mart Stores Inc., 99 cents Only Stores, and BJ's Wholesale Club Inc.--we see evidence of just such a tradeoff between NOPM and NOAT (see Exhibit 4).

However, providing actionable advice to clients or achieving specific performance goals for your firm requires even more detail. This leads to a closer examination of expense and turnover ratios for specific assets. Using the financial statements in GAAP format, we can calculate the ratios shown in Exhibit 5.

The large differences between cost of goods sold (CGS) to sales and selling, general and administrative expense to sales suggest that Target and Costco classify their costs into each major expense category differently. A review of the footnotes to the financial statements did not allow us to make the classifications comparable. Unfortunately, this problem also precludes unambiguous inferences about number of days inventory and number of days payables because both metrics include CGS. This is one of those examples where more detailed information from management is necessary to recast the income statement and balance sheet numbers on a comparable basis. Your clients should be able to provide this information.

[GRAPHIC OMITTED]

Property, plant & equipment (PP&E) turnover is much larger for Costco. However, an accounting issue that might affect this is the degree to which each company uses operating leases to finance stores and warehouses. The footnotes reveal that total minimum operating lease payments for Target and Costco are $3,325 and $1,894, respectively (in millions). Capitalizing these lease payments would make the PP&E turnover ratios converge somewhat. We conclude that Costco generates significantly more revenue per dollar of fixed assets than Target and that asset utilization appears to be an important value driver in its business model.

A related question is why Target's spread is so much larger than Costco's. It is unlikely that the cost of borrowing is dramatically different for the firms given their similar operating performance (and presumably similar risk of default). There is, unfortunately, insufficient disclosure in the financial statements and the footnotes to resolve this issue--reinforcing the adage that ratio analysis does not give you answers--it tells you what questions to ask.

DIFFERENT CONCLUSIONS?

Would our conclusions have been different if the original DuPont model of financial analysis had been applied to these companies? The answer is likely yes. Computing several key ratios using the original DuPont model yields the following:
 ROA/ NPM/ TAT/ LEV/
Target 7.7%/ 4.7%/ 1.64/ 2.42/
Costco 5.8% 1.7% 3.47 2.09


ROA = net income + average total assets

NPM = net profit margin = net income - revenue

TAT = total asset turnover = revenue + average total assets

LEV = financial leverage = average total assets + average stockholders equity

Using the original DuPont model, we would infer that Target's operating performance (ROA) is 33% better than Costcos--a much different conclusion than was reached using RNOA. And we would gather that Target uses somewhat more leverage than Costco (2.42 vs. 2.09), but the financial leverage for the firms (0.667 vs. 0.050) paints a much more radical picture of Target's use of debt (leverage in the original DuPont model mixes operating and financial liabilities).

We would not know the spread between operating performance (RNOA) and the cost of debt (NBC). For example, we don't know whether more interest-bearing debt would increase or decrease ROE.

ROE is accepted as the best profit metric to evaluate the performance of a business. However, the primary emphasis on financial ratio analysis must be on operating performance. That is, after all, where value creation takes place.

The advanced DuPont model permits a dean separation of operating and nonoperating performance and represents a state-of-the-art tool available for systematic analysis of company performance. Accountants must understand their employer's or clients' performance, both with respect to its own history and with respect to competitors in order to provide competent service. An understanding of the advanced DuPont model is a critical skill set in this endeavor.

AICPA RESOURCES

CPE

Financial Statement Analysis: Basis for Management Advice, a CPE self-study course (#731249)

Publications

* Guide to Financial Statement Analysis: Basis for Management Advice (#091022)

* Analyzing Financial Ratios Practice Aid-Forensic and Valuation Services Practice Aid 06-3 (#055302)

* Building Financial Models with Microsoft Excel: A Guide for Business Professionals (#W1661031)

For more information or to place an order, go to www.cpa2biz.com or call the Institute at 888-777-7077.

David C. Burns, CPA, DBA, J. Timothy Sale, CPA, Ph.D., and Jens A. Stephan, Ph.D., are accounting professors at the University of Cincinnati College of Business. Their e-mail addresses, respectively, are david.burns@uc.edu, tim.sale@uc.edu and jens.stephan@uc.edu.
Exhibit 1 Financial Statements
in Standard Form

 Target

Balance Sheet as of 28-Jan-06 3-Feb-07
Assets (in millions)
 Cash 1,648 813
 Receivables 5,666 6,194
 Inventories 5,838 6,254
 PP&E, Net 19,038 21,431
 Short-Term Investments 0 0
 Other assets 2,805 2,657
Total Assets 34,995 37,349

Liabilities
 Accounts Payable 8,835 9,755
 Interest-Bearing Debt 9,872 10,037
 Other Liabilities 2,083 1,924
Total Liabilities 20,790 21,716

Stockholders Equity
 Contributed Capital 2,192 2,216
 Retained Earnings 12,013 13,417
Total Stockholders Equity 14,205 15,633

Income Statement for Year Ending 28-Jan-06 3-Feb-07
 (in millions)

Revenues 52,620 59,490
 Cost of Revenue 34,927 39,399
Gross Profit 17,693 20,091
Operating Expenses
 SG&A 11,961 13,526
 Other 1,409 1,496
Operating Income (EBIT) 4,323 5,069
 Interest Expense 463 572
EBT 3,860 4,497
 Income Taxes 1,452 1,710
Net Income 2,408 2,787

 Costco

Balance Sheet as of 3-Sept-06 2-Sept-07
Assets (in millions)
 Cash 1,511 2,780
 Receivables 830 1,089
 Inventories 4,569 4,879
 PP&E, Net 8,564 9,520
 Short-Term Investments 1,322 576
 Other assets 699 763
Total Assets 17,495 19,607

Liabilities
 Accounts Payable 5,986 6,620
 Interest-Bearing Debt 565 2,222
 Other Liabilities 1,800 2,141
Total Liabilities 8,351 10,983

Stockholders Equity
 Contributed Capital 3,102 3,491
 Retained Earnings 6,041 5,132
Total Stockholders Equity 9,143 8,623

Income Statement for Year Ending 3-Sept-O6 2-Sept-07
 (in millions)

Revenues 60,151 64,400
 Cost of Revenue 52,745 56,450
Gross Profit 7,406 7,950
Operating Expenses
 SG&A 5,732 6,273
 Other (90) (97)
Operating Income (EBIT) 1,764 1,774
 Interest Expense 13 64
EBT 1,751 1,710
 Income Taxes 648 627
Net Income 1,103 1,083

Source: Yahoo! Finance, as of December 2007

Exhibit 2 Financial Statements
Reformulated for
DuPont Model

 Target

Balance Sheet as of 28-Jan-06 3-Feb-07
Operating Assets (in millions)
 Cash 1,648 813
 Receivables 5,666 6,194
 Inventories 5,838 6,254
 PP&E 19,038 21,431
 Other Assets 2,805 2,657
Total Operating Assets 34,995 37,349

Operating Liabilities
 Accounts Payable 8,835 9,755
 Other 2,083 1,924
Total Operating Liabilities 10,918 11,679
Net Operating Assets (NOA) 24,077 25,670
 Financial Assets 0 0
 Financial Liabilities 9,872 10,037
Net Financial Obligations (NFO) 9,872 10,037

Total Stockholders Equity 14,205 15,633

Income Statement (Reformulated) 28-Jan-06 3-Feb-07
for Year Ending (in millions)

Revenues 52,620 59,490
 Cost of Revenue 34,927 39,399
Gross Profit 17,693 20,091
Operating Expenses
 SG&A 11,961 13,526
 Other 1,409 1,496
Operating Income 4,323 5,069
 Taxes on Operating Income 1,626 1,928
NOPAT 2,697 3,141
 Net (After-Tax) Financing Expense (NFE) 289 354
Net Income 2,408 2,787

 Costco

Balance Sheet as of 3-Sept-06 2-Sept-07
Operating Assets (in millions)
 Cash 1,511 2,780
 Receivables 830 1,089
 Inventories 4,569 4,879
 PP&E 8,564 9,520
 Other Assets 699 763
Total Operating Assets 16,173 19,031

Operating Liabilities
 Accounts Payable 5,986 6,620
 Other 1,800 2,141
Total Operating Liabilities 7,786 8,761
Net Operating Assets (NOA) 8,387 10,270
 Financial Assets 1,322 576
 Financial Liabilities 565 2,222

Net Financial Obligations (NFO) (757) 1,646

Total Stockholders Equity 9,144 8,624

Income Statement (Reformulated) 3-Sept-06 2-Sept-07
for Year Ending (in millions)

Revenues 60,151 64,400
 Cost of Revenue 52,754 56,450
Gross Profit 7,406 7,950
Operating Expenses
 SG&A 5,732 6,273
 Other (90) (97)
Operating Income 1,764 1,774
 Taxes on Operating Income 653 650
NOPAT 1,111 1,124
 Net (After-Tax) Financing Expense (NFE) 8 41
Net Income 1,103 1,083

Note: NFO = interest-bearing debt--financial assets.

Exhibit 5 Expense and Turnover
Ratios

 Target Costco

Cost of goods sold to revenue 66.2% 87.7%
Selling, general and administrative
expense to revenue 22.7% 9.7%
Property, plant & equipment turnover 2.94 7.12
Number of days receivables 36 5
Number of days inventory 56 31
Number of days payables 86 41
COPYRIGHT 2008 American Institute of CPA's
No portion of this article can be reproduced without the express written permission from the copyright holder.
Copyright 2008 Gale, Cengage Learning. All rights reserved.

 Reader Opinion

Title:

Comment:



 

Article Details
Printer friendly Cite/link Email Feedback
Author:Burns, David C.; Sale, J. Timothy; Stephan, Jens A.
Publication:Journal of Accountancy
Date:Aug 1, 2008
Words:3493
Previous Article:Managing intellectual property.
Next Article:Long-term care insurance and tax planning: make the most of tax rules for premiums and benefits.
Topics:



Related Articles
Capacitance gauges prove their mettle in flat-film extrusion.
Pulling the levers to improve profitability.
Marketing's role in managing assets.
DuPont Refinish launches two surfacers.
Systematic approaches to digital forensic engineering; proceedings.
Quantitative equity portfolio management; modern techniques and applications.

Terms of use | Copyright © 2014 Farlex, Inc. | Feedback | For webmasters