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

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First, This Thing Called Debt

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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).

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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%

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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.

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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 capital10% * $700$70 Return on debt capital(10%-8%) * $300$6 Total return$76 $76/$700 = 10.9% ROROE

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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.

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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

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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

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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

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So, How Is Money Made? Through Three Primary Levers –By being efficient with your operations –By getting the most out of your assets –By leveraging your money that is, helping your own money do bigger and better things through borrowed use of someone else’s money.

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So, How Can I Analyze How I am Doing At Making Money, Or better yet how I might make more money? By analyzing each of the three levers that leads to Return on Equity – ROROE: –Efficiency of operations –How well assets are working into profits –Leverage

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Introducing the DuPont System for Financial Analysis

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DuPont System Developed in 1919 by a finance executive at E.I. du Pont de Nemours and Co “The DuPont system is a way of visualizing the information so that everyone can see it.” (Stephen Jablonsky, Penn State University) DuPont analysis “is a good tool for getting people started in understanding how they can have an impact on results” (Doug McCallen, Caterpillar Inc.) “Number one, it’s simple” (Sam Siegel, CFO)

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DuPont System “DuPont Financial Analysis Model is a rather straightforward method for assessing the factors that influence a firm’s financial performance.” (Gunderson, Detre, and Boehlje, AgriMarketing 2005)

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DuPont System – What is It? The system identifies profitability as being impacted by three different levers: 1.Earnings & efficiency in earnings 2.Ability of your assets to be turned into profits 3.Financial leverage Earnings Turnings Leverage

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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 DuPont System Earnings/Efficiency

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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 DuPont System Ratios OPMR ROROA ROROE ATO Total Assets/Total Equity Derived from the Debt To Asset Ratio (D:A)

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Let’s Do The Math

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

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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

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

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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

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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

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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

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NFIFO – unpaid labor/mgt + interest Total Revenue Total Revenue Total Assets Return On Assets Total Assets Total Equity Return On Equity X = X = Earnings Turnings Leverage cash income +(-) inventory changes cash expenses +(-) accrual exp changes + purch lstk Depr labor + depreciation + interest expenses OK Too Low OPMR ATO OK Too Low Total Revenue = Basic Costs = Non Basic Costs = OK Too Low -Too much labor given output - Not enough labor -Training and Education - Better systems and processes - Weekly/Daily staff meetings - Performance metrics

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NFIFO – unpaid labor/mgt + interest Total Revenue Total Revenue Total Assets Return On Assets Total Assets Total Equity Return On Equity X = X = Earnings Turnings Leverage OPMR ATO Too Low OK Too Low OK Too Low -Unproductive machinery? - Buildings not being used? - Breeding livestock not producing? - Unproductive land? - Over valued assets? Also, selling off unproductive assets and paying off debt could change your leverage position in a positive way, and also improve your ROROE!

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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

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

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NFIFO +int - unpd mgt11.72007 31,1573.42008 1,6656.125 yr avg OPM ÷4.1% 751,3480.2% 757,926 Earnings GR

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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

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