The DuPont Chain

The Du Pont Chain

• The Du Pont Chain is a formula, which shows that the rate of return on assets can be found as the product of the profit margin times the total assets turnover.

• The Du Pont Chain focuses on:– Expense control (Profit Margin)– Asset utilization (Total Asset Turn Over)– Debt utilization (Equity Management)

• It shows how these factors combine to determine the ROE.

Du Pont Chain

profit

equity

profit

sales

sales

assets

assets

equityx xx

Return on Sales

Asset Turnover

Leverage

=

Return on Equity

Return on Assets

==profit

assets

Company Operating Activities

Company Financin

g Activities

Business Operations Ratios RETURN ON SALES (ROS)

• ROS indicates the percentage of each sales dollar that results in profit.

• A high ROS suggests premium pricing. – This suggests the product will not be aimed at a

commodity market.

• ROS is also a good indicator of competition within the industry. – The more competitive an industry, the more pressure

there is on price and ROS will fall (airline industry).

Profit (return)

Sales (sales)

Business Operations Ratios ASSET TURNOVER (T/O)

• An asset in business is a resource that is owned or controlled that will provide future financial benefits to the company.

• Asset turnover is a measure of activity. How good are you at using your equipment to turn

• Cash into inventory • Inventory into sales (cash & A/R)

• High T/O values have implications in terms of the amount of assets employed and the aggressiveness of the pricing policy (Wal-Mart).

Sales

Assets

Business Operations Ratios RETURN ON ASSETS (ROA)

• Return on assets answers the question, “How good are we at producing wealth with our assets?”

• It compares the profits generated with the asset base required.

– Return on assets is an efficiency ratio.– How hard are you working your assets?

• An operating manager may be challenged with how a dollar spent on assets might do compared with the interest a firm is paying on the money borrowed to pay for the asset.

Profit (return)

Assets (assets)

Applying Ratios to Business Operations

ROS * Turnover = ROA

Profit * Sales = Profit Sales Assets Assets

Healthy ROA

A.High ROS (a lot of profit on each dollar of sales) * Low turnover (lower sales) = High ROA (Nordstrom)

B.Small ROS (not much profit on each dollar of sales) * High turnover = High ROA (high sales) (Wal-Mart)

Of Interest to Owners

• Leverage– Assets / Equity– How good were you at using the owners’

investment (leveraging) to acquire assets

• Return on Equity (ROE)– Net Income / Owners’ Equity– How much profit did you create using the

owners’ investment?

Of Interest to OwnersFINANCIAL LEVERAGE

• Leverage shows the debt level of the organization. • The financial structure of the firm is the relationship

between debt and equity.

• Without debt, your company's assets will not be as large. An example…

Assets

Equity

Making Use of Leverage

Common Stock (equity) $ 50,000

Bonds (@10%) (debt) $450,000

Funds Raised $500,000

Earnings $ 125,000

Less: Bond Interest $ 45,000

Total Earnings $ 80,000

Return on Equity

Profit $80,000

Equity $50,000

Common Stock (equity) $500,000

Bonds (@10%) (debt) 0

Funds Raised $500,000

Earnings $ 125,000

Total Earnings $ 125,000

Return on Equity

Profit $125,000

Equity $500,000 = 160% =25%

Are there benefits to having debt?  

• A company uses debt to purchase assets that produce income

– Without debt, your company's assets will not be as large.

– A competitor with identical equity could have assets worth two to three times as much as yours.

– If you can borrow money at 10% and make 20%, you should borrow all you can get.

• Profitable companies who use debt will typically be larger and more profitable than a company that does not use debt.

• Using debt instead of issuing stock will increase your earnings per share and keep your stockholders happier.

Assets

Equity

FINANCIAL LEVERAGE SPECTRUM

• A leverage of 1.0 means the company is entirely funded by equity. – Stockholders, including potential stockholders like a corporate

raider, will ask, “Why can’t management borrow, invest the money, and make profits on the borrowed funds?”

– Management can expect trouble at a leverage of 1.0.

• At a leverage of 2.0, for every dollar of equity, there is a dollar of debt. – Management and bankers will be happy, although stockholders

might pressure for more debt.

1 Assets 2

1 Equity 1

FINANCIAL LEVERAGE SPECTRUM

• At a leverage of 3.0, for every dollar of equity, there are two dollars of debt. – If the investments are good, stockholders will be delighted. – Management and debt holders will be modestly uncomfortable.

• At a leverage of 4.0, for every dollar of equity, there are three dollars of debt. – Even stockholders are likely to be uncomfortable. Management

might feel pressure to bring down the leverage.

3 Assets 4

1 Equity 1

Of Interest to OwnersRETURN ON EQUITY

• Return on Equity highlights for the stockholders the return on their investment.

• Return on equity tells you how effectively a company is using the dollars invested in it by stockholders.

Profit

Equity

Du Pont Chain

profit

equity

profit

sales

sales

assets

assets

equityx xx

Return on Sales

Asset Turnover

Leverage

=

Return on Equity

Return on Assets

==profit

assets

Du Pont Chain

profit

equity

profit

sales

sales

assets

assets

equityx xx

Return on Sales

Asset Turnover

Leverage

=

Return on Equity

Du Pont Chain

profit

equity

profit

sales

sales

assets

assets

equityx xx

Return on Sales

Asset Turnover

Leverage

=

Return on Equity

Return on Assets

==profit

assets