Dupont Analysis and Strategy

1. Dupont Analysis and Strategy P.V. Viswanath Financial Theory and Strategic Decision-Making

2. 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.

3. 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.)

4. 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.

5. 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 – EffInt Rate after tax) x (Net Debt/Equity) • =Op ROA + (Op ROA – EffInt Rate after tax) x Net fin leverage • = Op ROA + Spread x Net financial leverage

6. 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

7. 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.

8. Five Generic Competitive Strategies

9. How to Produce Cost Advantages • Perform value chain activities more cost-effectively than rivals • Economies of scale; manifests itself in lower COGS/Assets ratio – (better asset utilization) • Cost efficient supply-chain management • Reduce inventory costs – (lower assets) • Use online systems to achieve operating efficiencies (better COGS/Asset) • Revamp the firm’s overall value chain to eliminate or bypass some cost-producing activities altogether (e.g. outsourcing)

10. Corporate Examples • WalMart: streamlining orders, automation of distribution centers • Nucor Corporation: Using relatively inexpensive electric arc furnaces where scrap steel and directly reduced iron ore are melted. Makes the use of coal, coke and iron ore unnecessary; cuts investment in facilities and equipment (eliminating coke ovens, blast furnaces, basic oxygen furnaces, and ingot casters). • Southwest Airlines: no inflight meals, assigned seating; fast online reservation system; automated check-in equipment • Q: How do these activities affect the income statement and the balance sheet?

11. Differentiation Strategies • Incorporate Product attributes and user features that lower the buyer’s overall cost of using the product. • Incorporate features that raise product performance. • Incorporate features that enhance buyer satisfaction in noneconomic or intangible ways. • Differentiate on the basis of competencies and competitive capabilities that rivals don’t have or can’t afford to match

12. How to Differentiate • Product R&D activities – improved product design and performance features; e.g. Volvo or BMW • Supply Chain activities that affect the performance or quality of the company’s end product. Starbucks has a better product because it has strict specifications on the coffee beans. • Marketing, sales and customer service activities that result in superior technical assistance to buyers, faster maintenance and repair services, more and better product information for customers, more and better training materials for end users, better credit terms, quicker order processing etc.; e.g. Maytag

13. Low Cost Provider Strategy • Striving to achieve lower overall costs than rivals and appealing to a broad spectrum of customer, usually by underpricing rivals. • Marketing Tactic: Low Price • Operating Tactic: Economies of Scale

14. Broad Differentiation Strategy • Seeking to differentiate the company’s product offering from rivals’ in ways that will appeal to a broad spectrum of buyers. • Marketing Tactic: General Advertising – need to reach a broad audience; this could be broken down by advertising channel. Higher expenditures on general TV ads, relatively fewer on direct marketing. • Operating Tactic: Product R&D

15. Best-Cost Provider Strategy • Giving customers more value for the money by incorporating good-to-excellent product attributes at a lower cost than rivals. The objective is to have the lowest costs and prices compared to rivals offering products with comparable attributes. • Marketing Tactic: Direct marketing • Operating Tactic: R&D, efficient use of working capital

16. Focused Low-Cost Strategy • Concentrating on a narrow buyer segment and outcompeting rivals by having lower costs than rivals and thus being able to serve niche members at a lower price. • Marketing Tactic: Direct Marketing • Operating Tactic: Efficient use of working capital

17. Focused Differentiation Strategy • Concentrating on a narrow buyer segment and outcompeting rivals by offering niche members customized attributes that meet their tastes and requirements better than rivals’ products. • Marketing Tactic: Direct Marketing • Operating Tactic: R&D

18. Five Generic Competitive Strategies

19. Five Generic Competitive Strategies

20. Five Generic Strategies

21. A further decomposition? • If we separate Net Income into Sales – COGS – Direct Marketing expenses – General Advertising Expenses – Other expenses, we can write ROA as: • Sales/Assets x [1-DME/Sales-GAE/Sales-Other expenses/Sales] – COGS/Assets. • The inverse of Sales/Assets can be written as (NWC + Net Long-term Assets)/Sales and NWC can be further broken down, if necessary.