VideoMuch has been said in favor of new financial metrics that marry such elements as growth rate and stock price to a company's inner financial mechanisms. Like old friends, however, some seasoned metrics continue to deliver value if only by virtue of familiarity and simplicity. The most prominent among these is the DuPont system of financial analysis. Developed in 1919 by a finance executive at E.I. du Pont de Nemours and Co., of Wilmington, Delaware, in the days when the chemical giant cooked up financial formulae as well as hydrocarbons, the DuPont system still helps many companies visualize the critical building blocks in return on assets and return on investments.
"The DuPont model is a way of visualizing the information so that everyone can see it," says accounting and MIS professor Stephen Jablonsky of Penn State University. A typical DuPont chart resembles a chart drawn to mark the progress of competitors in a tennis or basketball tournament. Entries that ultimately make up before-tax return on investment include cost of goods sold, selling expenses, administrative expenses, inventories, accounts receivable, and cash. At successive stages, they are added, subtracted, divided, or multiplied until return on equity is reached.
In his new book, The Manager's Guide to Financial Statement Analysis, to be published in February by John Wiley & Sons, Jablonsky stresses DuPont's enduring appeal. "Where financial people are integrated into the business," says Jablonsky, "they use traditional measures of evaluating performance, such as profit margins, return on assets, and return on equity, all contained in the DuPont model."
Outside the cloistered confines of finance departments, where financial performance has not taken root among rank-and-file workers, the DuPont model can be very effective. DuPont analysis "is a good tool for getting people started in understanding how they can have an impact on results," says Doug McCallen, budgets and forecasts manager at construction and mining equipment maker Caterpillar Inc., in Peoria, Illinois, where performance has turned around since the company launched a reorganization in 1991. That was the year it formally heightened focus on specific accountabilities for different parts of the business. "The DuPont model supports and reinforces those accountabilities," says McCallen.
Using return on assets as a primary performance measure, and setting targets for each part of the organization, Caterpillar can determine when a problem is related to operating efficiency versus asset utilization. The results have been phenomenal, McCallen says. ROA has reached double digits, accompanied by record profits in 13 of the past 15 quarters, as of last September 30.
Nucor Corp., a $4 billion-a-year producer of steel and steel products, has been using return on assets employed to measure performance in its facilities for years, with salutary results. "Number one, it's simple," says Sam Siegel, vice chairman and chief financial officer of the Charlotte, North Carolina-based company. "All of our people understand it." Each facility aims for a 25 percent or greater return on assets employed, which is calculated before the effects of federal income tax, interest expense, and corporate overhead.
Thoughts from time to time about trading DuPont in for something else have yet to convince Siegel that something else is better. Alternatives, in his view, won't improve the company's incentives program. Nucor's overall profit-sharing plan is based on a 10 percent share of companywide pretax profits, and Siegel notes proudly that Nucor has consistently paid that amount into the plan since 1966, a year after new management took over after Martin Marietta sold its stake in the company.
ROOM FOR ERROR
The performance model that a company chooses should depend on its culture, Siegel contends. Lacking that affinity, models with extra bells and whistles will not fill the gap. Not so, say proponents of economic value added (EVA), who argue that the traditional ratio-based DuPont model suffers from a serious, if not fatal, flaw. They charge that guesswork inherent in generally accepted accounting principles leaves room for managers to make shortsighted decisions that boost return on investment without real improvement in the business. "Ratio measures can be very misleading and create conflicts between management and shareholders," warns Dennis Uyemura, senior vice president in charge of financial institutions at Stern Stewart & Co., the consulting firm that developed the EVA framework in 1983. EVA has won popularity in corporate circles by correlating favorable results with decisions that produce returns exceeding the cost of capital--a formula for creating shareholder value. It also shifts such costs as research and development from the expense category to capital investment.
Gary John Previts, a professor of accountancy at Case Western Reserve University's Weatherhead School of Management, in Cleveland, does not agree that DuPont is significantly more vulnerable to manipulation than newer methods. "Some would say the income behind return on investment is an estimate and not a fact, because income requires judgment," says Previts. "Depreciation is a guess and accrual-based measures are somewhat guessy." But by the same token, he observes, "people who believe in estimating cash flows have to estimate them in the future, and who can estimate that with precision? It involves subjective guessing, as well."
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