2. DuPont
Analysis for Banks
The profitability of the banking sector, has improved
significantly in the first seven years of the new millennium before the crisis
start up. This was a result of the general reform of the banking system (write
off of non-performing loans, privatization of state-owned banks, the
introduction of modern banking techniques, credit expansion, and the introduction
of the euro) and the high intermediation spread in these countries.[1]
The
analysis of the financial statements of a business includes besides the
selection of the appropriate index and the comparison, without which the
resulting conclusions do not have any meaning and most probably they do not
lead to the correct explanation. The comparison makes sense when it is done in
relation to time and in relation to the similar businesses or the sector. This
double comparison gives the capability of a more correct explanation of the
indexes and consequently of the business condition (Papoulias, 2000).
Profitability of banks is measured mainly by two
ratios. The Return on Equity (ROE) that increase the wealth of the shareholders
and the Return on Assets (ROA) that show to the investors how cable is the bank
management to yield earnings and how profitably use the hole assets of the
bank.
Saunders (2000) provides a model of financial analysis
for financial institutions that is based on the DuPont system of financial analysis
return on equity model. The return on equity model disaggregates performance
into the three components that determine return on equity: net profit margin,
total asset turnover, and the equity multiplier. The profit margin allows the
financial analyst to evaluate the income statement and the components of the
income statement. Total asset turnover allows the financial analyst to evaluate
the left-hand side of the balance sheet which is composed of the asset
accounts. The equity multiplier allows the financial analyst to evaluate the
right-hand side of the balance sheet which is composed of liabilities and
owners equity.
Return on equity analysis provides a system for
planning (budgeting) in addition to analyzing the financial institution’s
performance. The net profit margin allows the analyst to develop a pro forma
income statement. An abbreviated income statement would be composed of net
income equal to revenues minus expenses. The financial planner can determine
the projected revenue level needed to meet the target net income level. The
total asset turnover ratio permits the analyst to determine the total asset
level needed to generate the projected total revenue level. The total asset
requirement can be used to project the pro forma levels of all of the
asset accounts based on the target current asset to fixed asset level. The
fundamental equation of accounting is that assets equal liabilities plus owners
equity. The equity multiplier ratio can be used to determine the pro forma financial
needs and the financial structure of the financial institution.[2]
Return on equity, ROE, is first decomposed into return
on asset, ROA, and the equity multiplier, EM. Return on assets is decomposed
into net profit margin and total asset turnover:
ROE = (ROA) (EM) and ROA = (NPM) (TAT). Where, ROE =
return on equity, ROA = return on assets, EM = the equity multiplier, NPM = net
profit margin and TAT = total asset turnover
Return on equity is net income divided by total equity
capital and return on assets is net income divided by total assets. The equity
multiplier is the ratio of total assets and total equity capital.
ROE = (NI) / (TEC)
ROA = (NI) / (TA)
EM = (TA) / (TEC)
Where, NI = net income
TA = total asset
TEC = total equity capital
The equation for finding ROE is as follow:
ROE = Net
Profits / Total Equity (1)
Analyzing
the specific index of efficiency of the shareholders total equity, we can find
out if the purpose of achieving a satisfactory result has succeeded. When a
bank has losses ROE index is negative. When a bank has losses and negative
equity then the ROE ratio is also negative. This is because
in the numerator we get the absolute value of the negative earnings (ie losses) of the bank.
The equation for
finding ROA is as follow:
ROA = Net
Profits / Total Assets. (2)
Analyzing the
specific index we could:
·
Compare the
efficiency among the co-operative banks.
·
Observe the
efficiency through time.
·
Compare
efficiency of co-operative banks with the efficiency of the banking sector as a
whole.
·
Investigate the
reasons of the changes through time.
The DuPont system of financial analysis can be used to construct a
financial plan for the bank. The DuPont system of financial analysis provides a
means for the firm to monitor performance through the planning period and to
post-audit the planning process.
DuPont comes from DuPont Corporation that started
using this formula in 1920s. DuPont ratio analysis breaks down ROA (Return on
Assets) and ROE (Return on Equity) into three basic components that determine
profit efficiency, asset efficiency and leverage. This is an attempt to isolate
the causes of strength and weakness in the firm’s performance. DuPont focuses
on the expense control, assets utilization, and also debt utilization (Bodie, Zane; Alex Kane and Alan J. Marcus, 2004).
The Return on
total-Assets can be broken into two components. It equals the product of the
profit margin and total asset turnover ratio. Like the Return on total Assets,
Return on Equity can be broken down into component parts to tell us why the
level of return changes from year to year or why two banks’ returns on equity
differ. The Return on Equity is identical to Return on total Assets multiplied
by the Equity Multiplier. A bank’s Return on Equity may differ from one year to
the next, or from a competitor’s, as a result of differences in profit margin,
asset turnover, or leverage. Return on Equity directly reflects a bank’s use of
leverage or debt. If a bank uses relatively more liabilities to finance assets,
the Equity Multiplier will rise, and, holding other factors constant, the
firm’s Return on Equity will increase. This leveraging of a bank’s Return on
Equity implies only a greater use of debt financing. This breaking down of
Return on total Assets, and Return on Equity into their component parts is what
DuPont analysis is.
It is believed
that measuring assets at gross book value removes the incentive to avoid
investing in new assets. New asset avoidance can occur as financial accounting
depreciation methods artificially produce lower ROEs in the initial years that
an asset is placed into service. If ROE is unsatisfactory, the DuPont Analysis
helps locate the part of the business that is underperforming.
The Return on Equity model disaggregates performance into the three
components that determine Return on Equity: net profit margin, total asset
turnover, and the Equity Multiplier. The profit margin allows the evaluation of
the income statement and the components of the income statement. Total asset
turnover allows the evaluation on the left-hand side of the balance sheet which
is composed of the asset accounts. The Equity Multiplier allows the evaluation
of the right-hand side of the balance sheet which is composed of liabilities
and owners equity. Return on Equity analysis provides a system for planning
(budgeting) in addition to analyzing the financial institution’s performance.
The net profit margin allows the development of a pro forma income statement. An
abbreviated income statement would be composed of net income equal to revenues
minus expenses. The financial planner can determine the projected revenue level
needed to meet the target net income level. The total asset turnover ratio permits
the determination of the total asset level needed to generate the projected
total revenue level. The total asset requirement can be used to project the pro forma levels of all of the
asset accounts based on the target current asset to fixed asset level. The
fundamental equation of accounting is that assets equal liabilities plus owners
equity. The Equity Multiplier ratio can be used to determine the pro forma financial needs and
the financial structure of the financial institution.
DuPont
analysis simplified is similar with ROE even though it uses its own formula to
present the same results compiling together ROA and Equity Multiplier.
[1] “Does the Cross Border Mergers and Acquisitions of the
Greek Banks in the Balkan area affect on the course of profitability efficiency
and liquidity indexes of them”? Kyriazopoulos G., Petropoulos D., EBEEC Pitesti
2011
[2] Collier W. H., McGowan, B. Mc., Muhammad, Jr. J.,
(2010) “Evaluating the impact of a
rapidly changing economic environment on bank financial performance using the
DuPont system of financial analysis
[3] Evaluating the impact of a rapidly changing economic environment on
bank financial performance using the DuPont system of financial analysis, Henry
W. Collier, Carl B. McGowam & Junaina Muchammad, 2010.
[4] Essentials of Investments, Bodie, Zane; Alex Kane and Alan J. Marcus,
2004.
[5] Reviewing and Assessing financial information, techbooks, 2006.
[7] Evaluating the impact of a rapidly changing economic environment on
bank financial performance using the DuPont system of financial analysis, Henry
W. Collier, Carl B. McGowam & Junaina Muchammad, 2010.
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