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P.V. Viswanath
Financial Theory
and
Strategic Decision-Making
Standard Dupont Analysis
ROA = NI/TA
= (NI/Sales) x (Sales/TA)
= (Net Profit Margin) x (Asset Turnover)
ROE = NI/TE = ROA x (TA/TE)
= (NI/Sales) x (Sales/TA) x (TA/TE)
= Net Profit Margin x Asset Turnover x Equity Multiplier
Blunt instrument to monitor strategy because
The denominator in the ROA includes assets claimed by
all providers of capital, while the numerator includes only
return to providers of equity.
Assets include operating assets and financial assets
Net income includes income from operating activities, as
well as interest income and expense, which are the
consequence of financial decisions.
Alternative Decomposition
The key is to divide assets into operating assets and non-operating
assets, and similarly the liabilities into those associated with the firm’s
operations and those that are not.
Some of the firm’s long-term liabilities are non-interest bearing, such
as pension obligations, which are really part of the firm’s operations
rather than its financing.
We net the firm’s long-term assets net of these non-interest bearing
liabilities to get Net long-term assets.
Similarly, we would like to create a category of short-term assets that
includes all short operating assets, net of all short-term operating
liabilities. This gives us Operating Working Capital, defined as
(Current Assets – Cash and Marketable Securities) – (Current
Liabilities – Short term debt and current portion of long-term debt).
Net Assets = Net long-term assets + Operating Working
Capital
Net Debt = Total interest bearing liabilities – Cash and
Marketable Securities
(Cash is treated as negative debt, which is debatable.)
Alternative Decomposition
Similarly, we isolate and use net operating
profit, rather than using Net Income (which
includes interest).
This is done by adding back interest expense to
net income, after adjusting for their tax impact.
Similarly, interest income.
Thus, we first define (NIntAT) Net Interest
expense after tax as (Interest expense –
Interest Income)x(1-Tax rate).
Then Net Operating Profit After Taxes (NOPAT)
= Net Income + Net Interest Expense after
taxes; and Net Income = NOPAT – NIntAT.
Alternative Decomposition
ROE = (NOPAT/Equity) – (NIntAT /Equity)
= (NOPAT/Net Assets) x (Net Assets/Equity) –
(NIntAT)/Net Debt) x (Net debt/Equity).
If we rewrite Net Assets as Net Debt + Equity, we get
the following:
ROE = (NOPAT/Net Assets) x (1+Net Debt/Equity) –
NIntAT/Net Debt x (Net debt/Equity).
Defining NOPAT/Net Assets as Operating ROA and
combining terms with NIntAT/Net Debt (which is the
effective interest rate after tax on debt), we get
ROE = Op ROA + (Op ROA – Eff Int Rate after tax) x
(Net Debt/Equity)
=Op ROA + (Op ROA – Eff Int Rate after tax) x Net fin
leverage
= Op ROA + Spread x Net financial leverage
Alternative Decomposition
Since we are primarily interested in
using the Dupont decomposition to help
us in operating decisions, we can
further decompose Operating ROA.
Operating ROA = NOPAT/Sales x
Sales/Net Assets or
Operating ROA = NOPAT Margin x
Operating Asset Turnover
Dupont Analysis Applied
We now try to relate Dupont Analysis to
more specific operating strategies of the
firm.
In this process, we will have to extend
the Dupont decomposition even further.
Five Generic Competitive Strategies