dupont chain presentation 2
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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
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