CFA Level-I

Fi
Financial
i l Statement
St t
t Analysis
A l i Module
M d l

Dr. C. Bulent Aybar

Professor of International Finance

 The Du Pont system focuses on:

Profitability/Expense control (PM)
Efficiency/Asset utilization (TATO)
Leverage/Debt utilization (EM)

It shows how these factors are combined to determine the

ROE.

Dr. C. Bulent Aybar

DuPont System
ROE
ROE=(Profit
(Profit Margin)x(Asset Turnover)x(Equity Multiplier)
Profit Margin=NI/Revenues
Asset Turnover
Turnover=Revenues/Total
Revenues/Total Assets
Equity Multiplier=Total Assets/Equity

This could also be written as:

ROE=(EBIT/Revenues)x(EBT/EBIT)x[1-(Taxes/EBT)]x
(Re en es/Total Assets)x(Total
(Revenues/Total
Assets) (Total Assets/Equity)
Assets/Eq it )
In this form ROE expressed as a function of:
(Operating Margin) x (Effect of Non-Operating Items) x
(Tax Effect) x (Total Asset Turnover) x (Financial Leverage)
Dr. C. Bulent Aybar

 DuPont model is a very effective way of dissecting ROE to

its drivers. Analysts can penetrate into the black box of
ROE by inspecting its components or drivers.
Managers can gain insight regarding possible improvements
and its impact on ROE.
Du Pont model allows us to see the impact of profit margins,
non-operating income, taxes, efficiency of asset utilization,
and leverage on ROE!

Dr. C. Bulent Aybar

Example

Last year Central Chemicals had sales of $205,000,

$205 000
assets of $127,500, a profit margin of 5.3%, and an
equity
q y multiplier
p
of 1.2.
The CFO believes that the company could reduce its
assets by $21,000
$21 000 without affecting either sales or
costs.
Had it reduced its assets in this amount,
amount and had the
debt ratio, sales, and costs remained constant, by
how much would the ROE have changed?
Dr. C. Bulent Aybar

Solution
ROE
ROE=Profit
Profit Margin x Asset Turnover x Equity Multiplier

Current ROE =0.053 x (205,000/127,500) x 1.2=10.23%

New ROE=0.053
ROE=0 053 x (205
(205,000/106,500)x
000/106 500)x 11.2=12.24%
2=12 24%
Change in ROE=(12.24-10.23)=0.02016 or 2.02%

Dr. C. Bulent Aybar

Example
Last year Swensen Corp.
Corp had sales of $303
$303,225,
225 operating
costs of $267,500, and year-end assets of $195,000.
The debt-to-total-assets ratio was 27%,
%, the interest rate on
the debt was 8.2%, and the firm's tax rate was 37%.
The new CFO wants to see how the ROE would have been
affected if the firm had used a 45% debt ratio.
Assume that sales and total assets would not be affected, and
that the interest rate and tax rate would both remain constant.
By how much would the ROE change in response to the
change
h
i the
in
th capital
it l structure?
t t ?
Dr. C. Bulent Aybar

Base Case ROE

ROE (EBIT/Revenues)x(EBT/EBIT)x[1 (Taxes/EBT)]x

ROE=(EBIT/Revenues)x(EBT/EBIT)x[1-(Taxes/EBT)]x
(Revenues/Total Assets)x(Total Assets/Equity)
EBIT= ($303,225- $267,500)=35,725
($303,225- $267,500)/303,225=11.78%
Debt=Debt Ratio x Total Assets=0.27 x 195,000=52,650
Interest Expense=Debt
p
x Cost of Debt=52,650*0.082=4317.3
,
EBT/EBIT==(3572-4317.3)/35,725=0.8791
(1-Taxes/EBT)=(1-0.37)=0.63
Revenues/Total
R
/T t l Assets=303,225/195,000=1.55
A t 303 225/195 000 1 55
TA/Equity=1/(1-D/TA)=(1/0.73)=1.39

ROE=(0.1178)x(0.8791)x(0.63)x(1.55)x(1.39)=13.9%

Dr. C. Bulent Aybar

ROE with Debt Ratio of 45%

ROE (EBIT/Revenues)x(EBT/EBIT)x[1 (Taxes/EBT)]x

ROE=(EBIT/Revenues)x(EBT/EBIT)x[1-(Taxes/EBT)]x
(Revenues/Total Assets)x(Total Assets/Equity)
EBIT= ($303,225- $267,500)=35,725
($303,225- $267,500)/303,225=11.78%
Debt=Debt Ratio x Total Assets=0.45 x 195,000=87,750
Interest Expense=Debt
p
x Cost of Debt=87,750*0.082=7,196
,
,
EBT/EBIT==(3572-7,196)/35,725=28,529/35,725=0.7986
(1-Taxes/EBT)=(1-0.37)=0.63
Revenues/Total
R
/T t l Assets=303,225/195,000=1.55
A t 303 225/195 000 1 55
TA/Equity=1/(1-D/TA)=(1/0.55)=1.82

ROE=(0.1178)x(0.7986)x(0.63)x(1.55)x(1.82)=16.76%

Difference=16.8-13.9=2.9%
Dr. C. Bulent Aybar

Pro-forma Analysis
Pro forma financial statements are projected,
projected or forecast,
forecast
financial statements income statements and balance sheets.
The inputs required to develop pro forma statements using
the most common approaches include:
Financial statements from the pprecedingg yyear
The sales forecast for the coming year
Key assumptions about a number of factors

Dr. C. Bulent Aybar

Steps in Pro-forma Analysis

Step 1: Start with a Sales Forecast

The first and key input for developing pro forma financial statements is the
sales forecast

Step
p 2: Preparing
p
g the Pro Forma Income Statement
A simple method for developing a pro forma income statement is the
percent-of-sales method.
This method starts with the sales forecast and then expresses the cost of
goods sold, operating expenses, and other accounts as a percentage of
projected sales.

Step 3: Preparing the Pro Forma Balance Sheet

Probably the best approach to use in developing the pro forma balance sheet
is the judgmental approach.
Under this simple method, the values of some balance sheet accounts are
estimated and the companys external financing requirement
(deficiency/surplus ) is used as the balancing account.
Dr. C. Bulent Aybar

Downside of Pro-forma Analysis

The major weaknesses of the approaches to pro forma
statement development outlined above lie in two
assumptions:
Th
Thatt the
th firms
fi pastt financial
fi
i l performance
f
will
ill be
b replicated
li t d in
i the
th
future
That certain accounts can be forced to take on desired values

For these reasons, it is imperative to first develop a forecast

of the overall economy and make adjustments to
accommodate other facts or events.
The following simple example illustrates the technique:

Dr. C. Bulent Aybar

Garmin Inc. 2005 Income Statement

We are given Income Statement and Balance Sheet of Garmin Inc. for 2005
IncomeStatement
Revenues
Cost of Goods Sold
CostofGoodsSold
GrossProfit
SellingandGeneralAdministrativeExpenses
OperatingIncome
InterestExpense
EBT
Taxes
Net Income
NetIncome

2005 %ofSales
10,000
100%
5 500
5,500
55%
4,500
45%
800
8%
3,700
37%
500
5%
3,200
960
2 240
2,240

Garmin Inc. 2005 Balance Sheet

BalanceSheetEndofYear
Current Assets
CurrentAssets
NetPlantandEquipment
TotalAssets
CurrentLiabilities
LongTermDebt
ConnonStock&PaidinCapital
RetainedEarnings
Total Liabilities and Equity
TotalLiabilitiesandEquity
FinancingDeficiency(Surplus)

2005
2 000
2,000
18,000
20,000
1,000
5,000
500
13,500
20 000
20,000

%ofSales
20%
180%
200%
10%

200%

Proforma Income Statement and Balance Sheet

Assumptions:
Sales grow at 10% in 2006
The
Th following
f ll i do
d nott change
h
with
ith sales:
l
Taxes
Long
L
Term
T
Debt
D bt
Common Stock and Paid in Capital

Prepare the pro-forma

pro forma income statement and Balance sheet
assuming:
A-No dividends p
paid
B-50% payout
Dr. C. Bulent Aybar

Projected Income Statement -2006

IncomeStatement
Revenues
Revenues
CostofGoodsSold
GrossProfit
SellingandGeneralAdministrativeExpenses
g
p
OperatingIncome
InterestExpense
EBT
Taxes
NetIncome

2005
10 000
10,000
5,500
4,500
800
3,700
500
3,200
960
2,240

%
100%
55%
45%
8%
37%
5%

2006
11 000
11,000
6,050
4,950
880
4,070
500
3,570
1071
2,499

Note that Interest Expense and Taxes were not pro rated to sales! Since
We assumed no change in LT debt, interest expense remained constant!

Balance Sheet Under Two Assumptions

BalanceSheetEndofYear
CurrentAssets

2005

2006(A)

2006(B)

2,000

20%

2,200

2,200

NetPlantandEquipment

18,000

180%

19,800

19,800

TotalAssets

20,000

200%

22,000

22,000

CurrentLiabilities

1,000

10%

1,100

1,100

LongTermDebt

5,000

5,000

5,000

500

500

500

Retained Earnings
RetainedEarnings

13 500
13,500

15 999
15,999

14 750
14,750

TotalLiabilitiesandEquity

20,000

22,599

21,350

(599)

650.5

CommonStock&PaidinCapital

FinancingDeficiency(Surplus)

Under the assumption that no dividends are paid, there is a financing surplus.
We could reconcile this assuming capital expenditures, dividend payments or
Stock repurchases.