The Du Pont Analysis and the Company Finance Essay

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Free cash flow (FCF)

FCF = EBIT (1 – tax rate) + Depreciation & Amortization – change in net working capital – Capital expenditure

EBIT502,640
EBIT (1-40%) = 502,640 * (60%)301,584
Depreciation and amortization120,000
421,584
Net working capital in 2014 ( 2,680,112 – 1,039,800)1,640,312
Net working capital in 2013 (1,946,802 – 1,328,960)617,842
Change in net working capital(1,022,470)
Capital expenditure = Gross fixed asset in 2014 – fixed assets in 2013 (1,220,000 – 1,202,950)(17,050)
Free cash flow($617,936)

The company had a negative value of free cash flow. Further, there were no major capital investments. The negative free cash flow can be attributed to high working capital. Thus, the negative working capital is a sign that the company is unable to generate cash (Fridson and Alvarez 198).

Depreciation

EBT = 422640 – 120,000 = 302,640

Net income = 302,640 * (100% – 40%) = $181,584

Depreciation has an effect of reducing the net income because it is treated as an operating expense. Therefore, an increase in depreciation expense will cause the net income to decrease. However, the net income will decrease by only $72,000 and not $120,000. The difference is caused by depreciation tax shield (McLaney and Atrill 145).

Free cash flow

EBIT = 502,640

Less additional depreciation =120,000

Restated EBIT = 382,640

EBIT (1-40%) = 382,640 * (60%) = $229,584

Add depreciation = 240,000 = $449,584

Free cash flow = $449,584- 1,022,470 – 17,050 = -$569,936

Thus, growth in depreciation expense causes an increase in free cash flow. The value will increase by only $48,000 due to effect of taxes.

Current and quick ratio

Current ratio = Current assets / Current liabilities = 2,680,112 / 1,039,800 =2.58 times

Quick ratio = (Current assets – inventory) / Current liabilities = (2,680,112 – 1,716,480) / 1,039,800 = 0.93

The current ratio for the year 2013 was 1.5 while the quick ratio was 0.5. The current and quick ratio grew to 2.58 and 0.93 respectively in 2014. This shows an improvement in liquidity. The growth in liquidity can be attributed to a significant increase in inventory balance and receivables. The current liabilities also dropped. Thus, the improved liquidity can be seen as concealment of inefficiency in working capital management (Weygandt, Kieso, and Kimmel 139)

Du Pont analysis

Based on the Du Pont technique, the return on equity can be broken down into three components. These are net profit margin, total asset turnover, and equity multiplier (Drury 301). The return on equity for the company and the industry will be calculated and compared. The Du Pont identity is presented below.

Return on equity (ROE) = net profit margin * total asset turnover * equity multiplier

ComponentFormulaWorkings2014 ratios
Net profit marginNet income / sales253,584 / 7,035,6003.60%
Total asset turnoverSales / total assets7,035,600 / 3,516,9522.00 times
Equity MultiplierTotal Assets / total shareholders’ equity3,516,952 / 1,977,1521.79 times
Return on equity3.60% * 2.00 * 1.7912.8%

The Du Pont analysis is significant because it shows what drives the return on equity. The results show that the company is operating at a small margin. This can be an indication of inefficiency in managing operations (revenue and costs). The asset turnover was high. This shows that the company is efficient in the use of assets to generate sales. Finally, the equity multiplier shows that the company uses a high amount of debt (Deegan 129). Thus, it can be concluded that the company is efficient in generating a high level of sales from the assets. However, the major weakness is that the company is selling the products at a low margin. The company is also experiencing difficulties in controlling the leverage level (Brigham and Ehrhardt 249).

Works Cited

Brigham, Eugene, and Michael Ehrhardt. Financial Management Theory and Practice, Boston: South-Western Cengage Learning, 2009. Print.

Deegan, Craig. Financial Accounting Theory, London: McGraw-Hill, 2009. Print.

Drury, Colin. Management and Cost Accounting, Boston, USA: Cengage Learning, 2008. Print.

Fridson, Martin, and Fernando Alvarez. Financial Statement Analysis: A Practitioner’s Guide, New York: John Wiley & Sons, 2011. Print.

McLaney, Evans, and Peter Atrill. Financial Accounting for Decision Makers, London: Financial Times/Prentice Hall, 2008. Print.

Weygandt, Jerry, Donald Kieso, and Paul Kimmel. Financial Accounting, London: John Wiley & Sons Ltd, 2009. Print.

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