Custom Search

The Du Pont System

Some profitability or efficiency measures can be linked in useful ways. These relationships are often referred to as the Du Pont system, in recognition of the chemical company that popularized them. The first relationship links the return on assets (ROA) with the firm`s turnover ratio and its profit margin:

ROA = net income + interest = sales _ net income + interest assets assets sales asset profit turnover margin

All firms would like to earn a higher return on their assets, but their ability to do so is limited by competition. If the expected return on assets is fixed by competition, firms face a trade-off between the turnover ratio and the profit margin. Thus we find that fastfood chains, which have high turnover, also tend to operate on low profit margins. Hotels have relatively low turnover ratios but tend to compensate for this with higher margins.

Table A.11 illustrates the trade-off. Both the fast-food chain and the hotel have the same return on assets. However, their profit margins and turnover ratios are entirely different. Firms often seek to improve their profit margins by acquiring a supplier. The idea is to capture the supplier`s profit as well as their own. Unfortunately, unless they have some special skill in running the new business, they are likely to find that any gain in profit margin is offset by a decline in the asset turnover.

A few numbers may help to illustrate this point. Table A.12 shows the sales, profits, and assets of Admiral Motors and its components supplier Diana Corporation. Both earn a 10 percent return on assets, though Admiral has a lower profit margin (20 percent versus Diana`s 25 percent). Since all of Diana`s output goes to Admiral, Admiral`s management reasons that it would be better to merge the two companies. That way the

merged company would capture the profit margin on both the auto components and the assembled car.

The bottom line of Table A.12 shows the effect of the merger. The merged firm does indeed earn the combined profits. Total sales remain at $20 million, however, because all the components produced by Diana are used within the company. With higher profits and unchanged sales, the profit margin increases. Unfortunately, the asset turnover ratio is reduced by the merger since the merged firm operates with higher assets. This exactly offsets the benefit of the higher profit margin. The return on assets is unchanged. We can also break down financial ratios to show how the return on equity (ROE) depends on the return on assets and leverage:

ROE = earnings available for common stock = net income equity equity Therefore, ROE = assets _ sales _ net income + interest _ net income equity assets sales net income + interest leverage asset profit “debt ratio turnover margin burden”

Notice that the product of the two middle terms is the return on assets. This depends on the firm`s production and marketing skills and is unaffected by the firm`s financing mix.10 However, the first and fourth terms do depend on the debt-equity mix. The first term, assets/equity, which we call the leverage ratio, can be expressed as (equity + liabilities)/ equity, which equals 1 + total-debt-to-equity ratio.

The last term, which we call the “debt burden,” measures the proportion by which interest expense reduces profits. Suppose that the firm is financed entirely by equity. In this case both the first and the fourth terms are equal to 1.0 and the return on equity is identical to the return on assets. If the firm is leveraged, the first term is greater than 1.0 (assets are greater than equity) and the fourth term is less than 1.0 (part of the profits are absorbed by interest). Thus leverage can either increase or reduce return on equity. Leverage increases ROE when the firm`s return on assets is higher than the interest rate on debt.

DU PONT SYSTEM A breakdown of ROE and ROA into component ratios.