Financial Statement Analysis Blog #4 – Dupont analysis
“The financial discipline we have exercised has allowed us to establish a solid foundation poised for growth in the years ahead.”
As an investor, one should pay attention to the return generated from an investment opportunity. While the amount of the return may not be the sole driver of an investment decision, it still warrants a close look. When it comes to directly investing in a company (or buying one for that matter), it is important to look at the Return On Equity (ROE) as it measures the return a company generates on its equity capital – in other words, profitability.
For our example company Caterpillar (CAT) in this past 5-years period, the calculation revealed a declining ROE:
* calculated as the average of the ending balances of current and previous years.
As we can see, CAT’s ROE has declined between the period of 2011 and 2015.
A useful technique to understand what drives a company’s ROE is DuPont analysis (developed by the DuPont company). The technique decomposes ROE into basic ratios of five key performance indicators. Each indicator represents a distinct aspect of the company’s performance that affects ROE, allowing us to gauge how well the company has performed on that particular metric. These five indicators are profitability, operating profitability, efficiency, taxes, and use of financial leverage (debt). Performing this analysis over a period of time in the past helps pinpoint good and bad trends, as well as areas of improvements for company’s management. The DuPont analysis follows the following formula:
ROE = Net Income / Average shareholders' equity
ROE = (Net Income / Average total assets) * (Average total assets / Average shareholders' equity)
ROE = ROA * Leverage
ROE = (Net Income / Revenue) * (Revenue / Average total assets) * (Average total assets / Average shareholders' equity)
ROE = Net profit margin * Total asset turnover * Leverage
ROE = (Net Income / EBT) * (EBT / EBIT) * (EBIT / Revenue) * (Revenue / Average total assets) * (Average total assets / Average shareholders' equity)
ROE = Tax burden * Interest burden * EBIT margin * Total asset turnover * Leverage
Or, Profitability = tax effect * leverage effect * operating profitability effect * efficiency effect * leverage effect
Tax burden is defined as net income (profit) divided by earnings before taxes (consolidated profit before taxes). Interest burden is defined as earnings before taxes (EBT) divided by earnings before interest and taxes (EBIT).
For CAT, the picture looks like:
Leverage was calculated as follow:
CAT’s performance drivers can be identified as follow:
As we can see:
The tax burden has remained fairly constant over the last three-year period, indicating that the company maintained a fairly constant profit level or that there was no/little change in the company's tax rate.
Except for 2015, interest burden has declined for the company. The decrease in 2015 indicates a change in the company's capital structure
The EBIT margin (operating margin) has declined, especially over the last three-year period, indicating the company's operations were less profitable
The company's efficiency, as indicated by the total asset turnover, has been declining – especially in the past three years.
The company's leverage increased in 2015, after remaining flat the previous period and declining before that.
On operational flaws:
The declining ROE resulted from the decline in operating margin and the decline in total asset turnover. Additional analysis in later blog post will outline the causes.
The company is also not using its leverage well:
As we can see:
The company has leverage, and it has increased in the most recent year.
The declines in both ROE and ROA indicate that the company's borrowing cost exceeds its marginal rate (the rate it can earn investing borrowed money in its business), thus the company is NOT making an effective use of leverage. This observation is confirmed by how ROA has been depressed in 2015, bringing ROE down as leverage increased.
The Excel file that calculates the above figures and drive the conclusion is embedded.