Dr. P.V. Viswanath

pviswanath@pace.edu

Dupont Decomposition

• Traditional Decomposition
• Alternate Decomposition
• Use of Dupont Analysis for Marketing Strategy Decisions

Traditional Decomposition

• 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

However, the traditional decomposition is an imperfect instrument to monitor strategy for the following reasons:

• 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.

Alternate Decomposition

Here is an alternate decomposition of the ROA, keeping a strict separation between operating and financial activities.

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.)

Similarly, we isolate and use net operating profit, instead of 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 Net Interest expense after tax (NIntAT) as (Interest expense – Interest Income)x(1-Tax rate).
Then Net Operating Profit After Taxes (NOPAT) = Net Income + Net Interest Expense after taxes.
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

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

We now show the logic of this decomposition by reformulating the Balance Sheet and the Income Statement:

Balance Sheet Reformulation

We note that there are operating and financial assets on the left-hand side of the balance sheet; and, similarly, operating and financial liabilities on the right-hand side.  We make the following modifications to move all the operating items to the left-hand side and all the financial items to the right-hand side.
 

This can be further rewritten thus:

Let’s see how this would work with a specific case (Pepsico Inc.)

Let's use these numbers to compute some of the quantitites that we need for our Dupont decomposition:

This would be restated as follows:

We can also restate the Income statement in a comparable fashion to keep operating and financial elements separate.  These are numbers for the Pepsico Inc. for the year ending December 31, 2002.

Income Statement Reformulation:

We can also restate the Income statement in a comparable fashion to keep operating and financial elements separate.

Here is an alternate statement that keeps operating and financial items separate (income taxes of 1555 are split into 1683.24 less 128.24):

This can be shown more clearly by indicating which elements are operating, and which are operating (the important parts are at the bottom of the table):

Note that we have included bottling equity income as operating income by defining a new category of non-financial.  If such income/losses were non-recurring, they should be separated from operating income.  Often, however, such income may repeat every so often.  In that case, it would be better to include it along with the other operating income, as we have done here.  Pepsi, however, reported these separately.

This gives us the following alternate decomposition:

ROA = NOPAT/Sales x Sales/Total Operating Assets

For our example, we have:

We see that the traditional decomposition underestimates operating performance by counting financial assets as operating assets.

Use of Dupont Analysis for Marketing Strategy Decisions:

1. Once we look at the firm’s Dupont and other ratios (such as Sales/GSA Expense ratio), we might want to suggest that the firm move in the direction of increasing profit margin or in the direction of increasing volume.
2. This decision has to be taken, keeping in mind the capabilities and resources that the firm possesses.  It is also necessary to look at the competitive environment.  If there are many competing brands, then it might not be a valuable strategy to create a new brand, ab initio, in the same space.  All the other Porter framework forces have to be considered.
3. If the decision is to move in the direction of higher profit margin, then the firm has to think of a better brand.  It might want to look at the ratio of Sales to advertising expenses.
4. It might want to increase trade promotion efforts, as well.
5. If it pursues the goal of higher volume, then a lower price and all that it entails is indicated.  However, this may be achieved through different strategies, e.g. coupons or other off-price methods.  Better credit terms may also be an option.

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