EXECUTIVE SUMMARY
Return-on-equity (ROE) is
the correct profit metric to evaluate the
performance of a business. However,
the primary emphasis on financial ratio
analysis must be on operating performance.
The "advanced"
version of the DuPont model
remedies the original model’s failure
to cleanly separate the effects of operating
and financing decisions. It introduces the
concept of return on net operating assets
(RNOA) as the core measure of operating
performance and clearly separates the effects
of leverage and operating decisions.
The advanced model does
not change the result of the ROE
calculation. However, the elements underlying
the ROE ratio are different and provide a
clean separation of operating and financing
decisions.
RNOA is effectively
insulated from financing decisions.
Changing the amount of debt does not
affect the operating assets or the profit
before interest expense and, therefore, does
not affect RNOA. It also permits
straightforward computation of the impact on
ROE of alternative financing decisions.
Changes in the interest rate affect the
spread, while changes in the amount of debt
affect financial leverage in a transparent
manner.
David C. Burns, CPA, DBA,
J. Timothy Sale, CPA,
Ph.D., and Jens A. Stephan,
Ph.D., are accounting professors at the
University of Cincinnati College of
Business. Their e-mail addresses,
respectively, are
david.burns@uc.edu , tim.sale@uc.edu
and jens.stephan@uc.edu
.
R
atios provide a concise and systematic way
to organize the enormous quantity of data
contained in financial statements into a
framework that creates meaningful information.
Financial managers use ratios to benchmark their
firm’s performance against that of their
competitors and set goals for future
performance. Financial advisers use ratios to
identify underpriced or overpriced stocks and
make recommendations to investors.
Public accountants use ratios in nearly every
service they offer to their clients. In the
independent auditing arena, analytical procedures,
which include ratio analysis, have effectively
become a generally accepted auditing procedure
since SAS 56 was issued in April 1988.
Return-on-equity (ROE) is the ratio most
commonly used to analyze the profitability of a
business. The “original” DuPont ROE model, which
was created in 1919 by a finance executive at E.I.
du Pont de Nemours & Co., breaks ROE into
three fundamental drivers of accounting
returnon-equity: net profit margin, asset
utilization and financial leverage. An
“advanced” version of the DuPont model, which has
found its way into accounting textbooks over the
past several years, remedies the original model’s
failure to cleanly separate the effects of
operating and financing decisions. It introduces
the concept of return on net operating assets
(RNOA) as the core measure of operating
performance and clearly separates the effects of
leverage and operating decisions. This
article demonstrates the benefits of the advanced
DuPont model and uses the model to compare the
financial performance of two popular U.S.
retailers: Target and Costco.
THE ORIGINAL DUPONT MODEL OF FINANCIAL
ANALYSIS
The original DuPont model can be illustrated
with a simple example using two savings banks.
Assume that Bank A and Bank B are, respectively,
willing to pay 10% and 6% for deposits and are
also willing to lend at the same rates. An
all-equity firm with $1,000 in assets to invest
would clearly choose Bank A to earn an ROE =
Return on Assets (ROA) = 10%. Assume the firm pays
out all profits in the form of a cash dividend.
Using the original DuPont model to examine
the effects of financial leverage on ROE and ROA,
assume a firm borrows $800 from Bank B at 6%,
leaving an equity investment of $200. The reader
can verify that: Interest revenue = $100
Net income (NI) = $52 Assets = $1,000
Interest expense = $48 Equity = $200
ROE = $52 / $200 = 26.0% The model
disaggregates ROE into two components: ROA (NI /
Assets) and financial leverage (Assets / Equity).
This demonstrates the fundamental
shortcoming of the original DuPont model. The
decline in ROA from 10% to 5.2% could easily be
interpreted as lower operating performance.
However, in both examples, the firm’s managers
have invested all of the firm’s assets in Bank A,
still earning a 10% return. Therefore, many
seasoned analysts feel that the decline in ROA is
a false signal of a decline in the firm’s
operating performance. The model’s failure
to insulate the ROA ratio from the effects of
financing decisions is a major shortcoming in the
model and prompted the development of a variation
of the DuPont model. Here’s another way of
illustrating the significance of the problem:
Consider an operating manager who is entrusted
with $1,000 of assets and has been earning a 10%
return on assets. The CFO then decides to finance
some of the assets with debt instead of equity.
The ROA used to assess the operating manager’s
performance drops from 10% to 5.2%. In this case,
the operating manager does not have control over
capital structure decisions, yet his or her
performance metric (ROA) is being affected by the
financing decision. Alternatively, a
financial analyst or auditor using the model might
fail to take into account the separate effects of
operating and financing decisions on a firm’s ROA
and might reach erroneous conclusions about the
relative operating performance of levered and
un-levered firms. Finally, an auditor
applying the model might reach unwarranted
conclusions about a client’s operating performance
if the capital structure changed over time. These
simple examples illustrate the need for an ROE
model that distinguishes between the effects of
operating and financing decisions. The advanced
DuPont model has been developed to meet that need.
THE ADVANCED DUPONT MODEL OF FINANCIAL
ANALYSIS
The advanced DuPont model does not change
the result of the ROE calculation. However, the
elements underlying the ROE ratio are different.
The following examples demonstrate how the
advanced DuPont model allows for a clean
separation of operating performance—return on net
operating assets (RNOA)—and financing
decisions—financial leverage (FLEV) and spread—and
helps managers, analysts and CPAs avoid erroneous
conclusions from their financial statement
analyses. Using the earlier set of facts
to illustrate the use of the advanced DuPont
model, net income is computed as follows:
Note that the $200 in equity earns
10% while the $800 in debt earns 4% net of the
interest cost. ROE is defined as net income
divided by equity, so dividing by $200 yields the
following expression for ROE:
The notation of the advanced DuPont
model yields the following expression:
RNOA = $100 / $1,000 = 10%
Spread = RNOA – Interest Rate = 10% – 6% =
4% FLEV = Interest-Bearing Debt / Equity =
$800 / $200 = 4.0
RNOA is the appropriate metric to assess
management’s operating decision to invest the
assets in Bank A because it is effectively
insulated from the financing decision. Changing
the amount of debt does not affect the operating
assets or the profit before interest expense and,
therefore, does not affect RNOA. This remedies one
of the primary problems with the original DuPont
model. It also permits straightforward computation
of the impact on ROE of alternative financing
decisions. For example, changes in the interest
rate affect the spread while changes in the amount
of debt affect financial leverage in a transparent
manner.
A PPLICATION
We now apply the advanced DuPont model to
analyze the discount retailers Target Corp. and
Costco Wholesale Corp. Yahoo! Finance provides
financial statements in a standardized format
facilitating our analysis. See Exhibit 1 for the balance
sheets and income statements for both firms in
GAAP format. (Target officials reviewed this
article. A Costco investor relations official
could not be reached.)
Note that in our example, we include
Target’s credit card revenues/expenses and
Costco’s membership fees in the analysis. (Yahoo!
Finance provides only the total revenue number.)
Some financial analysts would exclude these items
to get a better picture of operating performance.
Both firms have nonsales related revenue of
approximately equal magnitude, so including the
figures should not affect the comparison in a
significant way. First, we calculate ROE
from the financial statements in GAAP format using
average stockholder equity in our calculation,
because the net income was earned evenly
throughout the year and the investment by owners,
therefore, changed evenly throughout the year. The
same rationale is applied for all balance sheet
items. The averages of beginning and ending
balances are used in the subsequent analyses. It
is worthwhile to note that both companies have
highly seasonal revenues and inventories. Using
average inventory levels based on beginning and
ending fiscal year values (when such levels are
unusually low), therefore, understates the true
average investment in inventories (operating
assets) throughout the year.
Next, we reformulate the financial
statements to distinguish between operating and
financing activities (see
Exhibit 2 ). Note that the balance sheet
calculates operating assets, operating liabilities
(the difference between these two is net operating
assets), financial assets (Target does not report
any financial assets in the form of investments in
marketable securities), and financial liabilities
(interest-bearing debt).
The difference between financial assets and
financial liabilities is net financial
obligations. Also, a firm with financial assets
greater than financial liabilities would
effectively have negative financial liabilities
(financial assets) and negative interest expense
(interest income). Similarly, the income
statement calculates net operating profit after
tax (NOPAT) and then subtracts after-tax interest
to arrive at net income, which is the same as in
the GAAP format. We are now ready to apply
the advanced DuPont model formulation to Target
and Costco. From Exhibit
2 , we reproduce the income statement and
balance sheet items shown in Exhibit 3 (all Target and
Costco financial statement numbers are in millions
and balance sheet numbers are averages of values
for the beginning and end of the year):
These variables are combined to verify that
the advanced DuPont model calculates the same ROE
as in the original DuPont model using the GAAP
formulation of the financial statements.
RNOA = NOPAT / NOA NBC = net
borrowing cost = NFE / NFO SPREAD = RNOA –
NBC FLEV = NFO / SE
Both firms have virtually identical
operating performance (RNOA). Target’s higher ROE
is almost entirely a result of financing effects.
The firm uses more financial leverage and has a
higher spread, which makes ROE almost 50% greater
than without financial leverage (Target’s credit
card business helps explain a portion of the
financial leverage difference). We now
understand how operating performance and
nonoperating performance combine to create return
on equity. To gain a better understanding of
operating performance, we can disaggregate it into
profit margin and asset turnover components. This
is accomplished in the following manner (note the
algebraic identity because revenue (REV) cancels
out):
NOPM = net operating profit margin
NOAT = net operating asset turnover
Target achieves its operating
performance with higher profit margins but lower
operating asset turnover. How do we know this is
strategy and not happenstance? Firms that choose a
cost leadership strategy will typically sell at
lower prices but with higher volume, while firms
that choose a differentiation strategy will sell
smaller quantities but at higher prices. Looking
at NOPM and NOAT for six firms in the discount
variety store industry— Target, Costco, Dollar
General Corp., Wal-Mart Stores Inc., 99¢ Only
Stores, and BJ’s Wholesale Club Inc.—we see
evidence of just such a tradeoff between NOPM and
NOAT (see Exhibit 4 ).
However, providing actionable advice to
clients or achieving specific performance goals
for your firm requires even more detail. This
leads to a closer examination of expense and
turnover ratios for specific assets. Using the
financial statements in GAAP format, we can
calculate the ratios shown in
Exhibit 5 .
The large differences between cost of goods
sold (CGS) to sales and selling, general and
administrative expense to sales suggest that
Target and Costco classify their costs into each
major expense category differently. A review of
the footnotes to the financial statements did not
allow us to make the classifications comparable.
Unfortunately, this problem also precludes
unambiguous inferences about number of days
inventory and number of days payables because both
metrics include CGS. This is one of those examples
where more detailed information from management is
necessary to recast the income statement and
balance sheet numbers on a comparable basis. Your
clients should be able to provide this
information. Property, plant &
equipment (PP&E) turnover is much larger for
Costco. However, an accounting issue that might
affect this is the degree to which each company
uses operating leases to finance stores and
warehouses. The footnotes reveal that total
minimum operating lease payments for Target and
Costco are $3,325 and $1,894, respectively (in
millions). Capitalizing these lease payments would
make the PP&E turnover ratios converge
somewhat. We conclude that Costco generates
significantly more revenue per dollar of fixed
assets than Target and that asset utilization
appears to be an important value driver in its
business model. A related question is why
Target’s spread is so much larger than Costco’s.
It is unlikely that the cost of borrowing is
dramatically different for the firms given their
similar operating performance (and presumably
similar risk of default). There is, unfortunately,
insufficient disclosure in the financial
statements and the footnotes to resolve this
issue—reinforcing the adage that ratio analysis
does not give you answers—it tells you what
questions to ask.
DIFFERENT CONCLUSIONS ?
Would our conclusions have been different if
the original DuPont model of financial analysis
had been applied to these companies? The answer is
likely yes. Computing several key ratios using the
original DuPont model yields the following:
ROA = net income ÷ average total
assets NPM = net profit margin = net income
÷ revenue TAT = total asset turnover =
revenue ÷ average total assets LEV =
financial leverage =average total assets ÷ average
stockholders equity
Using the original DuPont model, we would infer
that Target’s operating performance (ROA) is 33%
better than Costco’s—a much different conclusion
than was reached using RNOA. And we would gather
that Target uses somewhat more leverage than
Costco (2.42 vs. 2.09), but the financial leverage
for the firms (0.667 vs. 0.050) paints a much more
radical picture of Target’s use of debt (leverage
in the original DuPont model mixes operating and
financial liabilities We would not know
the spread between operating performance (RNOA)
and the cost of debt (NBC). For example, we don’t
know whether more interest-bearing debt would
increase or decrease ROE. ROE is accepted
as the best profit metric to evaluate the
performance of a business. However, the primary
emphasis on financial ratio analysis must be on
operating performance. That is, after all, where
value creation takes place. The advanced
DuPont model permits a clean separation of
operating and nonoperating performance and
represents a state-of-the-art tool available for
systematic analysis of company performance.
Accountants must understand their employer’s or
clients’ performance, both with respect to its own
history and with respect to competitors in order
to provide competent service. An understanding of
the advanced DuPont model is a critical skill set
in this endeavor
AICPA RESOURCES
CPE
Financial Statement Analysis: Basis for
Management Advice , a CPE self-study
course (#731249)
Publications
Guide to Financial
Statement Analysis: Basis for Management
Advice (#091022)
Analyzing Financial Ratios
Practice Aid—Forensic and Valuation
Services Practice Aid 06-3 (#055302)
Building Financial Models
with Microsoft Excel: A Guide for Business
Professionals (#WI661031) For
more information or to place an order, visit
www.cpa2biz.com
or call the Institute at 888-777-7077.
|