REALLY MODIFIED DU PONT ANALYSIS:

FIVE WAYS TO IMPROVE RETURN ON EQUITY

Thomas J. Liesz
Mesa State College

control as a chief cause of unsuccessful

Abstract businesses. Gill (1994) stresses the importance of
monitoring the “financial health” of a small
While the actual number of small business business. Thus, it would be useful for small
failures is often a topic of debate, the fact that business owners to have a relatively simple tool
poor financial planning and control ranks as one for not only assessing how their businesses are
of the top causes of business distress and ultimate faring, but also for devising strategies for bottom
failure has been widely documented. Further, line improvement. Such a tool exists in the form
owners and managers of both struggling and of an updated version of the classic Du Pont
successful small businesses alike often ponder model.
how to improve the return they are getting from
their enterprises. Ratio analysis provides a The Du Pont Model: A Brief History
wealth of information that is useful in this regard
and one type of analysis in particular – the The use of financial ratios by financial
modified Du Pont technique – can be used to analysts, lenders, academic researchers, and small
enhance decision making with an eye on business owners has been widely acknowleged in
improving return. This paper: 1) explains the the literature. (See, for example, Osteryoung &
development and mechanics of the “really” Constand (1992), Devine & Seaton (1995), or
modified Du Pont ratio model, 2) gives practical Burson (1998) The concepts of Return on Assets
direction for the use of the model, and 3) (ROA hereafter) and Return on Equity (ROE
discusses implications for the model’s use as a hereafter) are important for understanding the
strategic management tool for small business profitability of a business enterprise. Specifically,
owners, managers, and consultants. a “return on” ratio illustrates the relationship
between profits and the investment needed to
Introduction generate those profits. However, these concepts
are often “too far removed from normal activities”
Like many business students, a lot of small to be easily understood and useful to many
business owners and managers tend to shy away managers or small business owners. (Slater and
from quantitative analysis. The qualitative Olson, 1996)
aspects of a business – such as creating marketing In 1918, four years after he was hired by the Du
campaigns or dealing with customer service – are Pont Corporation to work in its treasury
far more “fun” than financial record keeping and department, electrical engineer F. Donaldson
analysis. However, there is much evidence that a Brown was given the task of untangling the
lack of financial control is often a quick path to finances of a company of which Du Pont had just
business failure. According to Dun & purchased 23 percent of its stock. (This company
Bradstreet’s Business Failure Records, “poor was General Motors!) Brown recognized a
financial practices” is second only to “economic mathematical relationship that existed between
conditions” as a cause of business failures. two commonly computed ratios, namely net profit
Further, studies such as those published by Bruno, margin (obviously a profitability measure) and
Leidecker, and Harder (1987); Gaskill, Van total asset turnover (an efficiency measure), and
Auken, and Manning (1993); Lauzen (1985); and ROA. The product of the net profit margin and
Wood (1989) specifically cite poor financial total asset turnover equals ROA, and this was the
original Du Pont model, as illustrated in Equation their modification they acknowlege that the
1 below. financial statements firms prepare for their annual
reports (which are of most importance to creditors
Eq. 1: (net income / sales) x (sales / total assets) and tax collectors) are not always useful to
= (net income / total assets) i.e. ROA managers making operating and financial
decisions. (Brigham and Houston, p. 52) They
At this point in time maximizing ROA was a restructured the traditional balance sheet into a
common corporate goal and the realization that “managerial balance sheet” which is “a more
ROA was impacted by both profitability and appropriate tool for assessing the contribution of
efficiency led to the development of a system of operating decisions to the firm’s financial
planning and control for all operating decisions performance.” (Hawawini and Viallet, p. 68)
within a firm. This became the dominant form of This restructured balance sheet uses the concept
financial analysis until the 1970s. (Blumenthal, of “invested capital” in place of total assets, and
1998) the concept of “capital employed” in place of
In the 1970s the generally accepted goal of total liabilities and owner’s equity found on the
financial management became “maximizing the traditional balance sheet. The primary difference
wealth of the firm’s owners” (Gitman, 1998) and is in the treatment of the short-term “working
focus shifted from ROA to ROE. This led to the capital” accounts. The managerial balance sheet
first major modification of the original Du Pont uses a net figure called “working capital
model. In addition to profitability and efficiency, requirement” (determined as: [accounts receivable
the way in which a firm financed its activities, i.e. + inventories + prepaid expenses] – [accounts
its use of “leverage” became a third area of payable + accrued expenses]) as a part of invested
attention for financial managers. The new ratio of capital. These accounts then individually drop out
interest was called the equity multiplier, which is of the managerial balance sheet. A more detailed
(total assets / equity). The modified Du Pont explanation of the managerial balance sheet is
model is shown in Equations 1 and 2 below. beyond the scope of this paper, but will be
partially illustrated in an example.
Eq. 2: ROA x (total assets / equity) = ROE The “really” modified Du Pont model is
shown below in Equation 4.
Eq. 3: (net income / sales) x (sales / total assets)
x (total assets / equity) = ROE Eq. 4: (EBIT / sales) x (sales / invested capital) x
(EBT / EBIT) x (invested capital / equity) x (EAT
The modified Du Pont model became a / EBT) = ROE
standard in all financial management textbooks
and a staple of introductory and advanced courses (Where: invested capital = cash + working capital
alike as students read statements such as: requirement + net fixed assets)
“Ultimately, the most important, or “bottom line”
accounting ratio is the ratio of net income to This “really” modified model still maintains
common equity (ROE).” (Brigham and Houston, the importance of the impact of operating
2001) The modified model was a powerful tool to decisions (i.e. profitability and efficiency) and
illustrate the interconnectedness of a firm’s financing decisions (leverage) upon ROE, but
income statement and its balance sheet, and to uses a total of five ratios to uncover what drives
develop straight-forward strategies for improving ROE and give insight to how to improve this
the firm’s ROE. important ratio.
More recently, Hawawini and Viallet (1999) The firm’s operating decisions are those that
offered yet another modification to the Du Pont involve the acquisition and disposal of fixed
model. This modification resulted in five assets and the management of the firm’s operating
different ratios that combine to form ROE. In assets (mostly inventories and accounts
receivable) and operating liabilities (accounts owner or manager who takes the (relatively little)
payable and accruals). These are captured in the time needed to understand it. Each operating and
first two ratios of the “really” modified Du Pont financial decision can be made within a
model. These are: framework of how that decision will impact ROE.
Easily set up on a computer model (such as a
1. operating profit margin: (Earnings Before spreadsheet), one can see how decisions “flow
Interest & Taxes or EBIT / sales) through” to the bottom line, which facilitates
2. capital turnover: (sales / invested capital) coordinated financial planning. (Harrington &
Wilson, 1986).
The firm’s financing decisions are those that In its simplest form, we can say that to
determine the mix of debt and equity used to fund improve ROE the only choices one has are to
the firm’s operating decisions. These are captured increase operating profits, become more efficient
in the third and fourth ratios of the “really” modi- in using existing assets to generate sales,
fied model. These are: recapitalize to make better use of debt and/or
better control the cost of borrowing, or find ways
3. financial cost ratio: (Earnings Before to reduce the tax liability of the firm. Each of
Taxes or EBT / EBIT) these choices leads to a different financial
4. financial structure ratio: (invested capital / strategy.
equity) For example, to increase operating profits one
must either increase sales (in a higher proportion
The final determinant of a firm’s ROE is the than the cost of generating those sales) or reduce
incidence of business taxation. The higher the tax expenses. Since it is generally more difficult to
rate applied to a firm’s EBT, the lower its ROE. increase sales than it is to reduce expenses, a
This is captured in the fifth ratio of the “really” small business owner can try to lower expenses by
modified model. determining: 1) if a new supplier might offer
equivalent goods at a lower cost, or 2) if a website
5. tax effect ratio: (Earnings After Taxes or might be a viable alternative to a catalog, or 3)
EAT / EBT) can some tasks currently being done by outsiders
be done in-house. In each case net income will
The relationship that ties these five ratios rise without any increase in sales and ROE will
together is that ROE is equal to their combined rise as well.
product. (See Equation 4.) Alternatively, to become more efficient, one
must either increase sales with the same level of
Example of Applying the “Really” assets or produce the same level of sales with less
Modified Du Pont Model assets. A small business owner might then try to
determine: 1) if it is feasible to expand store hours
To illustrate how the model works, consider by staying open later or on weekends, or 2) if a
the income statement and balance sheet for the less expensive piece of equipment is available that
fictitious small firm of Herrera & Company, LLC. could replace an existing (more expensive) piece
(See next page.) of equipment, or 3) if there is a more practical
way to produce and/or deliver goods or services
than is presently being used.
Conclusions & Implications Further, small business owners can determine
if they are using debt wisely. Refinancing an
The “really” modified Du Pont model of ratio existing loan at a cheaper rate will reduce interest
analysis can demystify relatively complex expenses and, thus, increase ROE. Exercising
financial analysis and put strategic financial some of an unused line of credit can increase the
planning at the fingertips of any small business financial structure ratio with a corresponding
increase in ROE. And, taking advantage of tax made as well as the financing and tax-related
incentives that are often offered by federal, state, decisions. The “really” modified Du Pont model
and local taxing authorities can increase the tax dissects ROE into five easily computed ratios that
effect ratio, again with a commensurate increase can be examined for potential strategies for
in ROE. improvement. It should be a tool that all business
In conclusion, ROE is the most compre- owners, managers, and consultants have at their
hensive measure of profitability of a firm. It disposal when evaluating a firm and making
considers the operating and investing decisions recommendations for improvement.

Income Statement

Net Sales …………………………………………………….. $766,990

Cost of Goods Sold ………………………………………….. (560,000)
Selling, General, & Administrative Expenses ………………. (143,342)
Depreciation Expense ……………………………………….. (24,000)
Earnings Before Interest & Taxes …………………………… $ 39,648
Interest Expense ……………………………………………... (12,447)
Earnings Before Taxes ………………………………………. $ 27,201
Taxes ………………………………………………………… (8,000)
Earnings After Taxes (net profit) ……………………………. $ 19,201

Balance Sheet

Cash ……………………….$ 40,000 Notes Payable ………………… $ 58,000

Pre-paid Expenses ………... 12,000 Accounts Payable …………….. 205,000
Accounts Receivable ……… 185,000 Accrued Expenses ……………. 46,000
Inventory ………………….. 200,000 Current Liabilities ……………. $309,000
Current Assets ……………. $437,000 Long-Term Debt
Land/Buildings …………… 160,000 Mortgage ……………………. 104,300
Equipment ………………… 89,000 8-Year Note ………………… 63,000
Less: Acc. Depreciation …... (24,000) Owner’s Equity ……………….. 185,700
Net Fixed Assets ………….. $225,000 Total Liabilities & Equity …….. $662,000
Total Assets ………………. $662,000

Computation of ROE

1. Operating Profit Margin = $39,648 / $766,990 = .0517

2. Capital Turnover = $766,990 / $411,000* = 1.8662
3. Financial Cost Ratio = $27,201 / $39,648 = .6861
4. Financial Structure Ratio = $411,000 / $185,700 = 2.2132
5. Tax Effect Ratio = $19,201 / $27,201 = .7059

ROE = .0517 x 1.8662 x .6861 x 2.2132 x .7059 = .1034** or 10.34%

* Invested Capital = Cash ($40,000) + Working Capital Requirement [$185,000 + $200,000 + $12,000] –
[$205,000 + $46,000] (or $146,000) + Net Fixed Assets ($225,000) = $411,000
** Note that this is the same as conventional computation of ROE: $19,201 / $185,700 = .1034
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