Essay Example on DuPont Model: Essential Financial Analysis Framework

Introduction

DuPont model is an essential framework that allows investors and other stakeholders to analyze the financial performance of a company. Through this technique, one can determine the relationship between different drivers of profitability ratios. The decomposition of profitability ratios allows corporate managers to identify weaknesses and strengths underlying individual parameters of Return on Investment (ROI) and Return on Equity (ROE). In this regard, the three financial aspects that influence ROE are financial leverage, the efficiency of assets utilization, and operating efficiency (Prendergast, 2006). Profit margin is used to determine operating efficiency, while the asset turnover ratio measures an organization’s efficiency of asset utilization. Equity multiplier metric, on the other hand, represents the financial leverage. This paper aims at researching the decomposition analysis of performance ratios at the Coca Cola and Pepsi Company and its relationship with common-size income statements.

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Research Question and Research Methods

The primary research question for this paper is: what is the relationship between the decomposition of profitability ratios (DuPont analysis) and common-size financial statements? The second research question is: what are the primary reasons for changes in ROE and ROI at Pepsis and Coca Cola Company? In this paper, the literature was synthesized and critically evaluated to determine how common-size income statements relate to disaggregation of profitability ratios. Also, DuPont's analysis based on the recent financial statements of the two companies was carried out to achieve the primary objective of the paper. Sources were retrieved by searching the keywords "DuPont analysis," "ROE decomposition," and "ROI disaggregation" in online databases. From this online search, eight sources were identified, but five of them were used because they were most relevant to the research questions. Besides, these sources were credible, insightful, and informative since they covered the subject in-depth.

Return on Equity

This financial metric denotes the efficiency of corporations in using shareholders’ equity to generate profits. Briefly, ROE is an indication of how well an organization or a business utilizes shareholder’s funds to grow its earnings. Often, good ROE ranges from 15% to 25% (Bodie et al., 2011). The higher this ratio, the better the company is using shareholder funds.

Coca Cola Company

The ROE is determined by multiplying asset turnover by financial leverage multiplier and the net profit margin. It is apparent from the disaggregation of this profitability ratio that Coca Cola's ROE increased continuously over three fiscal years (2017-2019). The primary reason for a significant increase in the company’s ROE is a continuous growth in profitability or earnings measured by net profit margin ratio. The second reason is an increase in asset efficiency, denoted by asset turnover. The relationship between these three financial metrics illustrates how changes in financial leverage, asset turnover, and profit margin influence the company’s Return on Equity (ROE).

Pepsi Company

ROE for Pepsi Company fluctuated between 2017 and 2019. While the corporation’s Return on Equity increased by more than seventy-five percent from 2017 to 2018, there was a significant decline in 2019. The company’s ROE in 2019 was lower than the initial figure in 2017. The major factor that contributed to a considerable decrease in ROE in 2019 is a downward trend in profitability reported in terms of the net profit margin ratio.

Return on Investment (ROI)

Returns on Equity and ROI of Pepsi is greater than that of its business rival, Coca Cola. However, Coca Cola's ROI was slightly higher than that of Pepsis in 2019. This phenomenon implies that Pepsi is better in using shareholders' money to generate income, although its annual profits are lower than that of Coca Cola. Also, ROI differences denote that Pepsi is a bit attractive to investors as its rate of return from capital projects exceeds that of Coca Cola, its competitor. DuPont analysis further shows that the assets turnover of Pepsi is better than that of Coca Cola. However, the profit margins of Coca Cola is greater than that of its competitor. This aspect suggests that the key strength of Coca Cola is higher operating efficiency, while the efficiency of asset use gives Pepsi a competitive edge over its competitor. From the perspective of ROI, a significant proportion of interest expense is a major weakness for Pepsi Company.

Potential investors are more likely to interpret Coca Cola’s ROE favorably since operational efficiency is the primary driver of higher profitability. While DuPont analysis is of great importance to corporate decision-makers and many other interested parties, researches have said that it has limitations (Chen & Zhao, 2009; Mitchell et al., 2013). Specifically, the usefulness of this framework entirely depends on the accuracy of the inputs (Mitchell et al., 2013). So, the model is not reliable if managers are fond of manipulating financial statements to achieve specific goals.

Decomposition Analysis and Common-Size Income Statements (CSIS)

CSIS and disaggregation analysis have a close relationship. According to Bodie et al. (2011), the relationship between these two components is the measure of returns or earnings that impact the company’s level of profitability in the future. In the case of Coca Cola and its competitor, Pepsis, Return on Equity (ROE) represent the profitability for the shareholders who support these corporations by providing equity capital. Returns on Equity and ROI uses the conventional profitability approaches to measure net income and operating returns against shareholders’ stock. Return on Assets (ROA) indicates the capability of a business entity to generate income when relating its assets and the profits (Gibson, 2013).

ROE and ROI decomposition for Coca Cola and its competitor, Pepsi, have demonstrated that profitability ratios can be used in vertical and horizontal analysis using common-size statements of comprehensive income. In the ROE illustration between the two corporations, it is evident that horizontal analysis of the financial metrics that drives ROI and ROE in the same reporting periods provides valuable information for comparing organizations.

Additionally, DuPont analysis provides a framework for comparing a single company's line items in income statements over two or multiple financial periods. In the disaggregation of ROE and ROI, for instance, investors and corporate decision-makers can compare trends in financial leverage, asset turnover, and net profit margins to know changes in the company's financial profitability across several financial periods. For instance, Coca Cola's financial leverage changed from 5.15 in 2017 to 4.9 in 2018 and finally to 4.55 in the year 2019. These parameters provide an opportunity to investigate factors driving fluctuations in a company's profitability. Besides, interested parties can compare the company's specific ROE and ROI drivers with that of the competitors and against industry standards. Together, these points illustrate a link between common-size income statements and disaggregation of profitability ratios.

Conclusion

DuPont analysis is vital to investors as it provides more insights into the financial components that drive corporations' profitability, including ROE and ROI. The three main factors that have significant impacts on ROI and ROE are asset turnover, profit margins, and the leverage factor. From the analysis of these parameters, investors and other interested parties can dissect the financial information of a company to determine how efficiently it generates sales and cash. This phenomenon suggests that DuPont analysis goes beyond profit margins to strengths and weaknesses that affect debt structures, inventory management, and so on.

From the decomposition and analysis of the two profitability ratios, the study showed that Pepsi has higher ROE and ROI metrics than its competitor, Coca Cola. However, ROE for the two corporations was equal in the year 2019. ROE for Coca Cola has an upward trend while that of Pepsis is declining. Growth in Coca Cola's profitability and a decline in the income of Pepsi, explains changes in ROE of the two organizations. The amount of returns that influence the profitability of a business entity in the future is the main factor that connects the decomposition of profitability ratios and common-size income statements. Ratios from ROE and ROI decomposition can be used in common-size financial statements for vertical and horizontal analysis. Investors can compare the historical data for the drivers of a company’s ROE and ROI and against that of the competitors.

References

Bodie, Z., Kane, A., & Marcus, A. J. (2011). Investments. McGraw- Hill Irwin. https://b-ok.africa/dl/599369/a7ce44

Chen, L., & Zhao, X. (2009). Return decomposition: Review of financial studies, 22(12), 5213-5249. https://doi.org/10.1093/rfs/hhp017

Gibson, C. H. (2013). Financial reporting and analysis: Using financial accounting information. Cengage Learning. https://b-ok.africa/dl/2717748/304c22