Operationalizing the Dupont Formula and More - Part 1

Financial ratios like ROI, ROA, and ROE are crucial performance measures used globally by companies. The tech industry has introduced a variety of financial and non-financial metrics, such as MAU (Monthly Average Users) and ARR (Annual Recurring Revenue), commonly used by startups seeking funding. Determining the optimal ratio is complex and depends on factors like company maturity, industry, and strategic priorities. After forty years of teaching at the Wisconsin School of Business, this post will expand on the profitability ratio taught in our Entrepreneurial Management course that, like the DuPont formula, provides a systematic way to identify the drivers of profitability and overcomes some of the weaknesses of historical ratios like Return on Equity/DuPont Formula.

The DuPont formula is a widely used financial ratio that dissects Return on Equity (ROE) into net profit margin, asset turnover, and equity multiplier. This analysis provides insight into a company's financial health and profitability factors.

The DuPont Formula:

Return on Equity = Net Earnings/Total Equity

Return on Equity = (Net Earnings/Total Assets) x (Total Assets/Total Equity)

Return On Assets x Leverage

Return on Equity = (Net Earnings/Sales) x (Sales/Total Assets) x (Total Assets/Total Equity)

Return on Sales x Asset Turnover x Leverage

The DuPont Formula, originating in the 1910s, breaks down factors influencing Return on Equity, offering:

• In-depth Understanding - enabling analysts to grasp specific drivers behind profitability, providing insights on operational efficiency, asset utilization, and financial leverage.

• Highlighting Areas for Enhancement - isolating components to pinpoint areas for performance improvement, such as inefficient asset utilization or cost management issues.

• Facilitating Comparative Analysis - simplifying comparisons between companies or industry standards.

• Supporting Strategic Financial Planning - guiding decision-making, setting financial objectives, optimizing capital structure, and enhancing financial performance.

The DuPont Formula, like other financial ratios, has its limitations due to its reliance on accounting data and historical context. It offers a restricted evaluation of financial health and may vary between industries. When analyzing Return on Equity (ROE), two crucial factors need to be considered. Firstly, the numerator (Net Earnings) excludes interest and tax payments, enabling companies to manipulate their ROE through financial decisions such as favoring debt over equity and utilizing tax strategies, potentially distorting the true profitability from core operations. Secondly, the denominator solely focuses on Equity while disregarding debt, allowing numerous companies to enhance their ROE by minimizing equity financing.

One way to address some of these issues with ROE and the DuPont Formula is to view them using different variables in the ROE equation that enable users of the information to see the drivers of change in profitability from a different viewpoint. One alternative is:

ROE = (1-T) x (ROAI + (Leverage*(ROAI - Cost of Debt)) where

• T = Effective Tax Rate of the firm, Tax Expense/Earnings Before Taxes

• ROAI = Earnings Before Interest Expense and Tax Expense (EBIT) / Asset Investment (AI). Recall, Asset Investment = Equity + Interest Bearing Debt

• Leverage (L) = Interest Bearing Debt/Equity, and

• Cost of Debt = Interest Expense/Interest Bearing Debt , this ratio estimates the interest rate paid on the firm's debt over the time period under study.

ROAI (has been discussed in a previous post) represents a more powerful profitability indicator because of its inclusion of EBIT in the numerator and all financing capital (debt and equity) in the denominator. But, what about the 'Cost of Debt'? The rationale for using Cost of Debt instead of a Weighted Average Cost of Capital as a benchmark hurdle rate is that we first want to determine if operating profits are making enough to cover the interest paid on the debt.

Example

The Dry Bean Company, a Midwest coffee house chain, will be analyzed as a case study for financial ratios. Despite its size, the company shows strong financial performance. The Return on Equity decreased from 156.4% in 2020 to 59.4% in 2022 due to substantial equity growth. The company retained a high percentage of net earnings. (Financials and ratios provided below)

IIn the years 2020-2022, the company witnessed a decrease in ROAI and spread due to a strategic reduction in leverage, achieved by retaining profits to bolster equity. Dry Bean maintains a strong ROE, with a significant indicator being the spread (meeting the +2% guideline). A spread falling below +2% or turning negative can indicate potential debt challenges, potentially leading to a "Debt Spiral" and the risk of bankruptcy. In 2022, Dry Bean further decreased its leverage. While it is prudent to steer clear of excessive debt, utilizing interest-bearing debt could enhance ROE in conjunction with equity. Shareholders may push for increased debt financing to yield higher returns on new ventures with lower capital costs compared to ROAI.

Conclusion

Return on Equity (ROE) is a key financial metric revealing a company's profitability and efficiency. Understanding ROE involves analyzing various factors influencing its fluctuations. Examining ROE from different angles uncovers trends and key drivers impacting financial performance.

For instance, analyzing Dry Bean's ROE can provide insights into its operations and financial health by dissecting components like net income and shareholder equity. Future articles will delve into Dry Bean's ROE results for a comprehensive analysis, aiming to identify challenges and optimize financial outcomes.

In future posts, we'll examine aligning the big number (e.g., ROE) with operations by deconstructing the formula.

	2020	2021	2022
ROAI (a)	117.8%	75.5%	79.6%
Cost of Debt (b)	18.7%	17.0%	16.2%
Spread (c=a-b)	99.1%	58.5%	63.4%
Leverage (d)	1.17	0.79	0.31
1-Tax Rt (e)	67.0%	59.9%	59.9%
ROE (a+(c x d))*e	156.4%	73.0%	59.4%

Return on Equity =

		2020	2021	2022
Net Income		122	130	202
Equity		78	178	340
ROE		156.4%	73.0%	59.4%

Return on Assets Invested

		2020	2021	2022
EBIT		199	241	354
Assets Inv
Equity		78	178	340
Int BearDebt		91	141	105
Assets Invested		169	319	445
ROAI		118%	76%	80%

Cost of Debt

		2020	2021	2022
Int Expense		17	24	17
IBD		91	141	105
Cost of Debt		18.7%	17.0%	16.2%

Spread = ROAI - Cost of Debt

		2020	2021	2022
Spread		99.1%	58.5%	63.4%

Leverage

		2020	2021	2022
IBD		91	141	105
Equity		78	178	340
Leverage		1.17	0.79	0.31

Effective Tax Rate

		2020	2021	2022
Tax Expense		60	87	135
EBT		182	217	337
Tax Rate		33.0%	40.1%	40.1%
1-Tax Rate		67.0%	59.9%	59.9%

Dry Bean Income Statement and Balance Sheet - 2020 - 2022

		2020	2021	2022
Sales		1354	1751	2299
Cost of Sales		800	1128	1580
Gross Margin	554	623	719
Operating Expenses	355	382	365
EBIT		199	241	354
Interest Expense	17	24	17
EBT		182	217	337
Income Tax		60	87	135
Net Income		122	130	202
Balance Sheet
		2020	2021	2022
Cash		281	73	16
Accounts Receivable	34	180	274
Inventory		68	188	115
Total Current Assets	383	441	405
Machinery and Equipment	129	156	420
Furniture and Fixtures	65	78	90
Accumulated Depreciation	-150	-181	-213
Net Fixed Assets	44	53	297
Other Non-Current Assets	5	5	5
Total Assets		432	499	707
Accounts Payable	254	170	252
Current Portion of L-T Debt	50	76	83
Other Accruals	9	10	10
Total Current Liabilities	313	256	345
Long-Term Debt	41	65	22
Total Liabilities	354	321	367
Owner's Equity	50	50	50
Retained Earnings	28	128	290
Total Equity		78	178	340
Liablitieis + Equity	432	499	707