1. DuPont System For Financial Analysis By Kevin Bernhardt, UW-Platteville and UW-Extension March 10, 2010 http://cdp.wisc.edu/Management.htm

2. First, This Thing Called Debt

3. Anatomy of Returns Total Assets = Total Liabilities + Total Equity Total amount of stuff used in the business to make profits (supplies, inputs breeding stock, machinery, etc.) How much of that stuff is financed by the “bank”, that is, debt capital. How much of that stuff is financed by your own money, that is, equity capital. So, when you make profits, those profits are a return to all the assets, some of which is a return to your money invested (equity capital) and some of which is a return to the bank’s money (debt capital).

4. Anatomy of Returns – Case 1 $1,000 of Total Assets (all financed by my own money) generated $500 of total revenue, $400 of total expenses, and thus $100 of profits. 100 1000 = $10 cents of income per dollar of asset ROROA = 10% Since it is all my money, then ROROE = 10%

5. Anatomy of Returns – Case 2 $1,000 of Total Assets (financed $700 by my own money and $300 @8% borrowed from a bank) generated $500 of total revenue, $400 of expenses before interest for $100 profit, and $76 profits after interest expenses. $700 76 700 = $300 My money (Equity Capital) Bank’s money (Debt capital) 100 1000 = $10.9 cents of income per dollar of your money Before interest $.10 cents of income per dollar of all assets used. Total Assets $1000 ROROA = 10% ROROE = 10.9% ROROA>i-rate The extra is payment to equity 10% 8% Thus 2% additional to Equity I leveraged someone else’s money to increase the return to my money.

6. Anatomy of Returns – Case 2 $1,000 of Total Assets (financed $700 by my own money and $300 @8% borrowed from a bank) generated $500 of total revenue, $400 of expenses before interest for $100 profit, and $76 profits after interest expenses. ROROA>i-rate Thus ROROE>ROROA (that’s good) Return on equity capital 10% * $700 $70 Return on debt capital (10%-8%) * $300 $6 Total return $76 $76/$700 = 10.9% ROROE

7. Anatomy of Returns – Case 3 $1,000 of Total Assets (financed $700 by my own money and $300 @8% borrowed from a bank) generated $500 of total revenue, $500 of expenses before interest for $0 profit, and -$24 profits after interest expenses. $700 -24 700 = $300 My money (Equity Capital) Bank’s money (Debt capital) 0 1000 = -$3.4 cents of income per dollar of your money Before interest $0 cents of income per dollar of all assets used. Total Assets $1000 ROROA = 0% ROROE = -3.4% Making 0% on all assets, but paying 8%, and the additional 8% is coming out of equity.

8. Anatomy of Returns – Case 3 $1,000 of Total Assets (financed $700 by my own money and $300 @8% borrowed from a bank) generated $500 of total revenue, $500 of expenses before interest for $0 profit, and -$24 profits after interest expenses. ROROA<i-rate Thus ROROE<ROROA (Not Good) Return on equity capital 0% * $700 $0 Return on debt capital (0%-8%) * $300 -$24 Total return -$24 -$24/$700 = -3.4% ROROE

9. Anatomy of Returns – Case 4 $1,000 of Total Assets (financed $700 by my own money and $300 @15% borrowed from a bank) generated $500 of total revenue, $400 of expenses before interest for $100 profit, and $55 profits after interest expenses. $700 55 700 = $300 My money (Equity Capital) Bank’s money (Debt capital) 100 1000 = $7.9 cents of income per dollar of your money Before interest $.10 cents of income per dollar of all assets used. Total Assets $1000 ROROA = 10% ROROE = 7.9% Making 10% on all assets, but paying 15% on debt portion (ROROA<i-rate), and the difference must come from equity.

10. Anatomy of Returns – Case 4 $1,000 of Total Assets (financed $700 by my own money and $300 @15% borrowed from a bank) generated $500 of total revenue, $400 of expenses before interest for $100 profit, and $55 profits after interest expenses. ROROA<i-rate Thus ROROE<ROROA (Not Good) Return on equity capital 10% * $700 $70 Return on debt capital (10%-15%) * 300 -$15 Total return $55 $55/$700 = 7.9% ROROE

13. Introducing the DuPont System for Financial Analysis DuPont

17. DuPont System Operating Profit Margin Asset Turnover Return On Assets (less interest adj.) Financial Structure Return On Equity X = X = Income Stream Investment Stream Turnings/Asset Use Leverage Earnings/Efficiency

18. DuPont System Ratios Operating Profit Margin Asset Turnover Return On Assets ( less interest adj.) Financial Structure Return On Equity X = X = Income Stream Investment Stream Earnings Turnings Leverage OPMR ROROA ROROE ATO Total Assets/Total Equity Derived from the Debt To Asset Ratio (D:A)

19. Let’s Do The Math

20. DuPont System Operating Profit Margin Asset Turnover Return On Assets (less interest adj.) Financial Structure Return On Equity X = X = Turnings/Asset Use Leverage Earnings/Efficiency

21. NFIFO + interest paid - unpaid labor/mgt ROROA = Total Assets NFIFO + interest pd – unpaid labor/mgt Total Revenue Total Revenue Total Assets Rate Of Return On Assets Operating Profit Margin Ratio Asset Turnover Ratio X

22. DuPont System Operating Profit Margin Asset Turnover Return On Assets (less interest adj.) Financial Structure Return On Equity X = X = Turnings/Asset Use Leverage Earnings/Efficiency

23. NFIFO – unpaid labor/mgt ROROE = Total Equity NFIFO + interest pd. – unpaid labor/mgt Total Assets Total Assets Total Equity Rate Of Return On Equity Rate Of Return On Assets Leverage Ratio - interest pd. Total Assets i-rate Adj. = NFIFO – unpaid labor/mgt Total Assets X

24. Net Farm Income From Operations (NFIFO) NFIFO = Total Revenue – Basic Costs – Non Basic Costs sales, govt. pmts, custom work +(-) inventory changes cash expenses +(-) accrual expense changes labor + depreciation + interest expenses NFIFO = Total Revenue – COGS – Operating Expenses – Interest

25. Return On Assets Total Assets Total Equity Return On Equity X = Leverage Leverage is the mix of debt versus equity capital used in making profits. - Do we have too much debt? - Do we have enough debt? - Is our debt capital generating profits? - Can our debt capital be put to better use? OK Too Low Too Low

28. Financial Diagnostics via DuPont. Finding the Red Flags! ROROE too Low ROROA too Low Revenues too low for costs Unused or Under Utilized Assets Obsolete or Inefficient Assets Leverage Wrong Kind of Debt Not Enough Debt OPM too Low ATO too Low Costs too high for Revenues Prices Production Quality Facilities Processes Operations Health Labor Repairs Timeliness Management Ability to Manage Assets

29. End http://cdp.wisc.edu/Management.htm

30. NFIFO + int - unpd mgt 11.7 2007 31,157 3.4 2008 1,665 6.12 5 yr avg OPM ÷ 4.1% 751,348 0.2% 757,926 Earnings GR

31. NFIFO – unpaid labor/mgt ROROE = Total Equity NFIFO – unpaid labor/mgt + interest pd. ROROA = Total Assets NFIFO – unpaid labor/mgt + interest pd. OPMR = Total Revenue Total Revenue ATO = Total Assets Total Assets Financial Structure = Total Equity Rate Of Return On Equity Rate Of Return On Assets Operating Profit Margin Ratio Asset Turnover Ratio Leverage Ratio