Accounting: The Language of Business - Vol. 2 (Intermediate: Part 87)

Andre Tippett was an impact player who consistently played at a level that set him apart. Accounting for him limited what an offense could do. He made quarterbacks nervous.and rightly so.

Raymond Berry

Statements of Financial Position and Cash Flows and the Annual Report (Part X)

by

Charles Lamson

DuPont Analysis

Profitability enables a company to generate a return for its shareholders. Specifically, the return on equity (ROE) ratio measures the return on shareholders' investment in the company. This return is enhanced by effective use of available resources to increase revenue.

 Dupont Analysis is a financial statement analysis tool that separates ROE into components to analyze a company's sources of profitability. We focus on the form of the DuPont Analysis that indicates how a company uses debt financing to increase its return to shareholders. In subsequent parts, we will discuss other forms of the DuPont Analysis to further analyze additional aspects of profitability.

We begin with ROE, which is net income divided by average stockholders' equity:

ROE = Net Income / Average Stockholders' Equity (6B.5)

We expand the ratio by dividing net income by average total assets and multiplying by average total assets divided by average stockholders' equity:

(6B.6)

As noted in Part 62, net income divided by average total assets is return on assets (ROA). The second part, average total assets divided by average stockholders' equity, is another leverage ratio, called financial leverage. The lower the ratio, the lower the financing from debt. A higher ratio indicates more debt financing and higher leverage. ROE is also expressed as follows:

ROE = Return on Assets X Financial Leverage (6B.7)

From Equation 6B.7, observe that a company with a high ROA can generate a high ROE. High financial leverage also increases ROE. Exhibit 6B.2 illustrates the effect of financial leverage on return on equity. When ROA is constant, a company can increase its ROE by increasing its financial leverage. 

EXHIBIT 6B.2 Effect of Financial Leverage on Return on Equity

Therefore, shareholders can benefit from increased profitability when a company uses debt financing. However, too much debt can increase a company's risk of bankruptcy.

EXAMPLE 6B.3 DuPont Analysis of Johnson & Johnson Company, 2016 and 2015 

PROBLEM: In Part 62, we computed Johnson & Johnson's return on equity (ROE) as 23.6% and 21.9% in 2016 and 2015, respectively. Use the DuPont analysis to determine whether this increase in ROE is due to a change in return on assets or financial leverage. The following information is relevant:

SOLUTION: Using equation 6B.6 we compute ROE using the DuPont Analysis as follows:

Separating ROE into ROA and financial leverage indicates that Johnson & Johnson's ROA increased to 12.05% in 2016 from 11.68% in 2015 representing an approximate 3.2% increase from the prior year [(12.05% - 11.68%) / 11.68%]. The company's financial leverage also increased to 1.959 in 2016 from 1.872 in 2015. This is approximately a 4.6% increase from the prior year [{1.959 - 1.872) / 1.872]. The increase in financial leverage and increase in ROA suggest that Johnson & Johnson's increase in ROE is due both to the increasing ROA and financial leverage. 

*GORDON, RAEDY, SANNELLA, 2019, INTERMEDIATE ACCOUNTING, 2ND ED., PP. 311-313*

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