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Principles of Finance

6.6 Profitability Ratios and the DuPont Method

Principles of Finance6.6 Profitability Ratios and the DuPont Method

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Table of contents
  1. Preface
  2. 1 Introduction to Finance
    1. Why It Matters
    2. 1.1 What Is Finance?
    3. 1.2 The Role of Finance in an Organization
    4. 1.3 Importance of Data and Technology
    5. 1.4 Careers in Finance
    6. 1.5 Markets and Participants
    7. 1.6 Microeconomic and Macroeconomic Matters
    8. 1.7 Financial Instruments
    9. 1.8 Concepts of Time and Value
    10. Summary
    11. Key Terms
    12. Multiple Choice
    13. Review Questions
    14. Video Activity
  3. 2 Corporate Structure and Governance
    1. Why It Matters
    2. 2.1 Business Structures
    3. 2.2 Relationship between Shareholders and Company Management
    4. 2.3 Role of the Board of Directors
    5. 2.4 Agency Issues: Shareholders and Corporate Boards
    6. 2.5 Interacting with Investors, Intermediaries, and Other Market Participants
    7. 2.6 Companies in Domestic and Global Markets
    8. Summary
    9. Key Terms
    10. CFA Institute
    11. Multiple Choice
    12. Review Questions
    13. Video Activity
  4. 3 Economic Foundations: Money and Rates
    1. Why It Matters
    2. 3.1 Microeconomics
    3. 3.2 Macroeconomics
    4. 3.3 Business Cycles and Economic Activity
    5. 3.4 Interest Rates
    6. 3.5 Foreign Exchange Rates
    7. 3.6 Sources and Characteristics of Economic Data
    8. Summary
    9. Key Terms
    10. CFA Institute
    11. Multiple Choice
    12. Review Questions
    13. Problems
    14. Video Activity
  5. 4 Accrual Accounting Process
    1. Why It Matters
    2. 4.1 Cash versus Accrual Accounting
    3. 4.2 Economic Basis for Accrual Accounting
    4. 4.3 How Does a Company Recognize a Sale and an Expense?
    5. 4.4 When Should a Company Capitalize or Expense an Item?
    6. 4.5 What Is “Profit” versus “Loss” for the Company?
    7. Summary
    8. Key Terms
    9. Multiple Choice
    10. Review Questions
    11. Problems
    12. Video Activity
  6. 5 Financial Statements
    1. Why It Matters
    2. 5.1 The Income Statement
    3. 5.2 The Balance Sheet
    4. 5.3 The Relationship between the Balance Sheet and the Income Statement
    5. 5.4 The Statement of Owner’s Equity
    6. 5.5 The Statement of Cash Flows
    7. 5.6 Operating Cash Flow and Free Cash Flow to the Firm (FCFF)
    8. 5.7 Common-Size Statements
    9. 5.8 Reporting Financial Activity
    10. Summary
    11. Key Terms
    12. CFA Institute
    13. Multiple Choice
    14. Review Questions
    15. Problems
    16. Video Activity
  7. 6 Measures of Financial Health
    1. Why It Matters
    2. 6.1 Ratios: Condensing Information into Smaller Pieces
    3. 6.2 Operating Efficiency Ratios
    4. 6.3 Liquidity Ratios
    5. 6.4 Solvency Ratios
    6. 6.5 Market Value Ratios
    7. 6.6 Profitability Ratios and the DuPont Method
    8. Summary
    9. Key Terms
    10. CFA Institute
    11. Multiple Choice
    12. Review Questions
    13. Problems
    14. Video Activity
  8. 7 Time Value of Money I: Single Payment Value
    1. Why It Matters
    2. 7.1 Now versus Later Concepts
    3. 7.2 Time Value of Money (TVM) Basics
    4. 7.3 Methods for Solving Time Value of Money Problems
    5. 7.4 Applications of TVM in Finance
    6. Summary
    7. Key Terms
    8. CFA Institute
    9. Multiple Choice
    10. Review Questions
    11. Problems
    12. Video Activity
  9. 8 Time Value of Money II: Equal Multiple Payments
    1. Why It Matters
    2. 8.1 Perpetuities
    3. 8.2 Annuities
    4. 8.3 Loan Amortization
    5. 8.4 Stated versus Effective Rates
    6. 8.5 Equal Payments with a Financial Calculator and Excel
    7. Summary
    8. Key Terms
    9. CFA Institute
    10. Multiple Choice
    11. Problems
    12. Video Activity
  10. 9 Time Value of Money III: Unequal Multiple Payment Values
    1. Why It Matters
    2. 9.1 Timing of Cash Flows
    3. 9.2 Unequal Payments Using a Financial Calculator or Microsoft Excel
    4. Summary
    5. Key Terms
    6. CFA Institute
    7. Multiple Choice
    8. Review Questions
    9. Problems
    10. Video Activity
  11. 10 Bonds and Bond Valuation
    1. Why It Matters
    2. 10.1 Characteristics of Bonds
    3. 10.2 Bond Valuation
    4. 10.3 Using the Yield Curve
    5. 10.4 Risks of Interest Rates and Default
    6. 10.5 Using Spreadsheets to Solve Bond Problems
    7. Summary
    8. Key Terms
    9. CFA Institute
    10. Multiple Choice
    11. Review Questions
    12. Problems
    13. Video Activity
  12. 11 Stocks and Stock Valuation
    1. Why It Matters
    2. 11.1 Multiple Approaches to Stock Valuation
    3. 11.2 Dividend Discount Models (DDMs)
    4. 11.3 Discounted Cash Flow (DCF) Model
    5. 11.4 Preferred Stock
    6. 11.5 Efficient Markets
    7. Summary
    8. Key Terms
    9. CFA Institute
    10. Multiple Choice
    11. Review Questions
    12. Problems
    13. Video Activity
  13. 12 Historical Performance of US Markets
    1. Why It Matters
    2. 12.1 Overview of US Financial Markets
    3. 12.2 Historical Picture of Inflation
    4. 12.3 Historical Picture of Returns to Bonds
    5. 12.4 Historical Picture of Returns to Stocks
    6. Summary
    7. Key Terms
    8. Multiple Choice
    9. Review Questions
    10. Video Activity
  14. 13 Statistical Analysis in Finance
    1. Why It Matters
    2. 13.1 Measures of Center
    3. 13.2 Measures of Spread
    4. 13.3 Measures of Position
    5. 13.4 Statistical Distributions
    6. 13.5 Probability Distributions
    7. 13.6 Data Visualization and Graphical Displays
    8. 13.7 The R Statistical Analysis Tool
    9. Summary
    10. Key Terms
    11. CFA Institute
    12. Multiple Choice
    13. Review Questions
    14. Problems
    15. Video Activity
  15. 14 Regression Analysis in Finance
    1. Why It Matters
    2. 14.1 Correlation Analysis
    3. 14.2 Linear Regression Analysis
    4. 14.3 Best-Fit Linear Model
    5. 14.4 Regression Applications in Finance
    6. 14.5 Predictions and Prediction Intervals
    7. 14.6 Use of R Statistical Analysis Tool for Regression Analysis
    8. Summary
    9. Key Terms
    10. Multiple Choice
    11. Review Questions
    12. Problems
    13. Video Activity
  16. 15 How to Think about Investing
    1. Why It Matters
    2. 15.1 Risk and Return to an Individual Asset
    3. 15.2 Risk and Return to Multiple Assets
    4. 15.3 The Capital Asset Pricing Model (CAPM)
    5. 15.4 Applications in Performance Measurement
    6. 15.5 Using Excel to Make Investment Decisions
    7. Summary
    8. Key Terms
    9. CFA Institute
    10. Multiple Choice
    11. Review Questions
    12. Problems
    13. Video Activity
  17. 16 How Companies Think about Investing
    1. Why It Matters
    2. 16.1 Payback Period Method
    3. 16.2 Net Present Value (NPV) Method
    4. 16.3 Internal Rate of Return (IRR) Method
    5. 16.4 Alternative Methods
    6. 16.5 Choosing between Projects
    7. 16.6 Using Excel to Make Company Investment Decisions
    8. Summary
    9. Key Terms
    10. CFA Institute
    11. Multiple Choice
    12. Review Questions
    13. Problems
    14. Video Activity
  18. 17 How Firms Raise Capital
    1. Why It Matters
    2. 17.1 The Concept of Capital Structure
    3. 17.2 The Costs of Debt and Equity Capital
    4. 17.3 Calculating the Weighted Average Cost of Capital
    5. 17.4 Capital Structure Choices
    6. 17.5 Optimal Capital Structure
    7. 17.6 Alternative Sources of Funds
    8. Summary
    9. Key Terms
    10. CFA Institute
    11. Multiple Choice
    12. Review Questions
    13. Problems
    14. Video Activity
  19. 18 Financial Forecasting
    1. Why It Matters
    2. 18.1 The Importance of Forecasting
    3. 18.2 Forecasting Sales
    4. 18.3 Pro Forma Financials
    5. 18.4 Generating the Complete Forecast
    6. 18.5 Forecasting Cash Flow and Assessing the Value of Growth
    7. 18.6 Using Excel to Create the Long-Term Forecast
    8. Summary
    9. Key Terms
    10. Multiple Choice
    11. Review Questions
    12. Problems
    13. Video Activity
  20. 19 The Importance of Trade Credit and Working Capital in Planning
    1. Why It Matters
    2. 19.1 What Is Working Capital?
    3. 19.2 What Is Trade Credit?
    4. 19.3 Cash Management
    5. 19.4 Receivables Management
    6. 19.5 Inventory Management
    7. 19.6 Using Excel to Create the Short-Term Plan
    8. Summary
    9. Key Terms
    10. Multiple Choice
    11. Review Questions
    12. Video Activity
  21. 20 Risk Management and the Financial Manager
    1. Why It Matters
    2. 20.1 The Importance of Risk Management
    3. 20.2 Commodity Price Risk
    4. 20.3 Exchange Rates and Risk
    5. 20.4 Interest Rate Risk
    6. Summary
    7. Key Terms
    8. CFA Institute
    9. Multiple Choice
    10. Review Questions
    11. Problems
    12. Video Activity
  22. Index

By the end of this section, you will be able to:

  • Calculate profit margin to determine how much sales revenues the firm has translated into income.
  • Evaluate firm performance by calculating return on total assets and return on equity.
  • Analyze organizational performance using DuPont method calculations.

Profitability considers how well a company produces returns given its operational performance. The company needs to use its assets and operations efficiently to increase profit. To assist with profit goal attainment, company revenues need to outweigh expenses. Let’s consider three profitability measurements and ratios: profit margin, return on total assets, and return on equity.

Profit Margin

Profit margin represents how much of sales revenue has translated into income. This ratio shows how much of each $1 of sales is returned as profit. The larger the ratio figure (the closer it gets to 1), the more of each sales dollar is returned as profit. The portion of the sales dollar not returned as profit goes toward expenses. The formula for profit margin is

Profit Margin=Net IncomeNet SalesProfit Margin=Net IncomeNet Sales

For Clear Lake Sporting Goods, the profit margin in the current year is

Profit Margin=$35,000$120,000=0.29 (rounded) or 29%Profit Margin=$35,000$120,000=0.29 (rounded) or 29%

This means that for every dollar of sales, $0.29 returns as profit. If Clear Lake Sporting Goods thinks this is too low, the company would try to find ways to reduce expenses and increase sales.

Return on Total Assets

The return on total assets measures the company’s ability to use its assets successfully to generate a profit. The higher the return (ratio outcome), the more profit is created from asset use. Average total assets are found by dividing the sum of beginning and ending total assets balances found on the balance sheet. The beginning total assets balance in the current year is taken from the ending total assets balance in the prior year. The formula for return on total assets is

Return on Total Assets=Net IncomeAverage Total AssetsReturn on Total Assets=Net IncomeAverage Total Assets
Average Total Assets=(Beginning Total Assets + Ending Total Assets)2Average Total Assets=(Beginning Total Assets + Ending Total Assets)2

For Clear Lake Sporting Goods, the return on total assets for the current year is

Average Total Assets=($200,000+$250,000)2=$225,000Average Total Assets=($200,000+$250,000)2=$225,000
Return on Total Assets=$35,000$225,000=0.16 (rounded) or 16%Return on Total Assets=$35,000$225,000=0.16 (rounded) or 16%

The higher the figure, the better the company is using its assets to create a profit. Industry standards can dictate what an acceptable return is.

Return on Equity

Return on equity measures the company’s ability to use its invested capital to generate income. The invested capital comes from stockholders’ investments in the company’s stock and its retained earnings and is leveraged to create profit. The higher the return, the better the company is doing at using its investments to yield a profit. The formula for return on equity is

Return on Equity=Net IncomeAverage Stockholder EquityReturn on Equity=Net IncomeAverage Stockholder Equity
Average Stockholder Equity=Beginning Stockholder Equity + Ending Stockholder Equity2Average Stockholder Equity=Beginning Stockholder Equity + Ending Stockholder Equity2

Average stockholders’ equity is found by dividing the sum of beginning and ending stockholders’ equity balances found on the balance sheet. The beginning stockholders’ equity balance in the current year is taken from the ending stockholders’ equity balance in the prior year. Keep in mind that the net income is calculated after preferred dividends have been paid.

For Clear Lake Sporting Goods, we will use the net income figure and deduct the preferred dividends that have been paid. The return on equity for the current year is

Average Stockholder Equity=90,000+100,0002=95,000Average Stockholder Equity=90,000+100,0002=95,000
Return on Equity=$35,000-$5,000$95,000=0.32 (rounded) or 32%Return on Equity=$35,000-$5,000$95,000=0.32 (rounded) or 32%

The higher the figure, the better the company is using its investments to create a profit. Industry standards can dictate what an acceptable return is.

The DuPont Method

ROE in its basic form is useful; however, there are really three components of ROE: operating efficiency (profit margin), asset usage (total asset turnover), and leverage (equity ratio). This is known as the DuPont method. It originated in 1919 when the DuPont company implemented it for internal measurement purposes.2 The DuPont method can be expressed using this formula:

ROE =Profit Margin× Total Asset Turnover × Equity MultiplierROE =Profit Margin× Total Asset Turnover × Equity Multiplier

Profit margin indicates how much profit is generated by each dollar of sales and is computed as shown:

Profit Margin = Net IncomeNet SalesProfit Margin = Net IncomeNet Sales

Total asset turnover indicates the number of sales dollars produced by every dollar invested in capital assets—in other words, how efficiently the company is using its capital assets to generate sales. It is computed as shown:

Equity Multiplier=Average Total AssetsAverage Stockholders' EquityEquity Multiplier=Average Total AssetsAverage Stockholders' Equity

The equity multiplier measures leverage. It is computed as shown:

Equity Multiplier=Average Total AssetsAverage Stockholders' EquityEquity Multiplier=Average Total AssetsAverage Stockholders' Equity

Using DuPont analysis, investors can see overall performance broken down into smaller pieces, which helps them better understand what is driving ROE. We already have the computations for Clear Lake Sporting Goods’ profit margin and total asset turnover:

Profit Margin=$35,000$120,000=0.29 (rounded) or 29%Profit Margin=$35,000$120,000=0.29 (rounded) or 29%
Total Asset Turnover =$120,000$225,000=0.53 times (rounded)Total Asset Turnover =$120,000$225,000=0.53 times (rounded)

We can calculate the equity multiplier using the equity multiplier equation and prior calculations for Clear Lake’s average total assets and average stockholder equity:

Equity Multiplier=Average Total AssetsAverage Stockholders' EquityEquity Multiplier=Average Total AssetsAverage Stockholders' Equity
Average Total Assets=$200,000 + $250,0002=$225,000Average Total Assets=$200,000 + $250,0002=$225,000
Average Stockholder Equity=$90,000+$100,0002=$95,000Average Stockholder Equity=$90,000+$100,0002=$95,000
Equity Multiplier=$225,000$95,000=2.37Equity Multiplier=$225,000$95,000=2.37

Now that we have all three elements, we can complete the DuPont analysis for Clear Lake Sporting Goods:

ROE=Profit Margin × Total Asset Turnover × Equity MultiplierROE=Profit Margin × Total Asset Turnover × Equity Multiplier
ROE=29% × 0.53 × 2.37 = 0.36 or 36.4%ROE=29% × 0.53 × 2.37 = 0.36 or 36.4%

Performance Analysis

ROE captures the nuances of all three elements. A good sales margin and a proper asset turnover are both needed for a successful operation. Like all ratios, assessing performance is relative. It’s important to look at the ratio in context of the organization, its history, and the industry. If we compare Clear Lake’s ROE of 26.4% to the recreational products industry average of 12.56% for the same year, it would appear as though Clear Lake Sporting Goods is outperforming the general industry. However, recreational products can include a wide variety of businesses beyond just the outdoor gear in which Clear Lake Sporting Goods specializes. An analyst could look at other key competitors such as Cabela’s or Bass Pro Shops to get even more relevant comparisons.

Clear Lake Sporting Goods is also technically a retail store, albeit a specialized one. An analyst might also consider the industry averages for general or online retail of 20.64% and 27.05%, respectively. Compared to the broader retail industry, Clear Lake Sporting Goods is still performing well, but its performance is not as disparate to industry average as when compared to recreational products (see Table 6.1).

Industry ROE (%)
Advertising 2.93
Air Transportation −47.03
Computer Services 13.50
Banking 8.22
Financial Services (nonbanking) 64.28
Food Processing 10.12
Renewable Energy −20.59
Hospitals/Health Care Facilities 70.64
Hotels/Gaming −30.40
Publishers −14.18
Recreational Products 12.56
Real Estate (general) 2.00
Retail: 0.00
        Automotive 36.28
        Building Supply 0.27
        General 20.64
        Grocery 30.63
        Online 27.05
Rubber and Tires −26.69
        Shoes 23.70
        Software (systems and applications) 28.09
Transportation 21.47
Total Market Average 8.25
Table 6.1 Return on Equity by Industry in 2020 It’s important to look at any ratio in context of the organization, its history, and the industry. (data source: Aswath Damodaran Online)

Footnotes

  • 2Joshua Kennon. “What Is the DuPont Method Return on Equity, or ROE, Formula?” The Balance. December 16, 2020. https://thebalance.com/the-dupont-model-return-on-equity-formula-for-beginners-357494
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