Improving profitability is almost a constant objective of every business owner.
First, to increase anything, we must be able to measure it first. A popular metric of profitability is the Return on Equity ("ROE"). This can be expressed mathematically as shown below:
ROE = Profit After Tax / Shareholder's Equity
A DuPont analysis can be conducted to understand the factors driving the profitability of your business. This can be done by expanding on the ROE formula as demonstrated:
ROE = Net Profit Margin X Asset Turnover X Leverage
Profit After Tax = Profit After Tax x Sales x Assets
Shareholders' Equity Sales Assets Shareholders' Equity
Net Profit Margin
The Net Profit Margin shows you how much money you're making per dollar of sales. By comparing your Net Profit Margin against industry benchmarks, you would be able to know how your business is faring against the competition. Besides that, you can also compare your Net Profit Margin over the past few financial years to identify any worrying trends. Have costs been creeping up gradually in recent years? Are you overpaying for inventory or labour? Perhaps there is wastage of inventory or consumables not being managed properly. On the other hand, could you be undercharging your customers? Maybe your customers derive a greater value from your products or services than you realise. Performing this analysis allows you to see where you stand and whether your future initiatives are effective in improving profitability.
Asset Turnover
The second component is Asset Turnover. This measures how efficient your business is at generating sales per dollar of asset which you own. A higher ratio indicates that your business is more efficient at generating sales. Generally, capital-intensive businesses would require more assets to generate sales and result in a lower ratio. Since assets have to be financed either by debt or equity, many companies are turning to an asset-light business model so that the business can become financially more agile and nimble, enabling it to navigate the increasingly fast-changing and uncertain business environment. One such example is Keppel, which outlined their asset-light approach with disciplined capital allocation in their Vision 2030 statement.
You can start by identifying inefficiencies to determine whether there are any assets which are not generating sufficient returns. Is your business holding too much cash? Perhaps this cash could be redeployed elsewhere or invested into fixed deposits or mutual funds to reap higher returns. Or could the inventory levels be too high? Accurate forecasting of sales and demand can help to reduce overstocking and the risk of inventory obsolescence. These are some of the methods you can adopt to improve your Asset Turnover.
Leverage
Finally, the last component is leverage. Since total assets is the sum of liabilities and equity, a leverage ratio of more than 1 would only occur when the business employs debt. Most business owners shun debt as debt has a bad reputation. Everyone has heard horror stories about how other businesses have gone bankrupt due to debt. However, debt, if managed correctly, can be used to enhance your returns on your business. Let's see a hypothetical example below:
Assumptions:
Total investment into business = $1,000
Profit after tax (annual) = $100
Interest rate on Debt = 5% per annum
Scenario A: Business 100% funded by Equity
Total Equity = $1,000
Profit after tax = $100
Return on Equity = $100 / $1,000 = 10%
Scenario B: Business 50% funded by Equity, 50% funded by Debt
Total Equity = $500
Total Debt = $500
Profit after tax (before interest) = $100
Interest expense = 5% X $500 = $25
Profit after tax and interest = $100 - $25 = $75
Return on Equity = $75 / $500 = 15%
Assuming the business operations remain exactly the same while the capital structure of the business is amended, the return on equity could improve significantly from 10% to 15% just by undertaking debt.
Of course, excessive leverage puts the business at a higher risk of bankruptcy. Therefore, leverage must be carefully monitored. One way is to calculate the interest coverage ratio, which is represented by the formula below:
Interest Coverage = Earnings Before Interest and Tax / Interest Expense
This figure shows you how much your earnings would have to drop in relation to your interest expense for the year. The higher the number, the lower the likelihood of your business being unable to meet the interest obligation.
Conclusion
The DuPont analysis can be a useful tool for you to form a deeper understanding of the drivers of profit, allowing you to design more tailored solutions to improving your profitability and returns.
*Written on 4th August 2021