On efficiency and leverage

Writing about Colefax's profitability, I wanted to go one stage further and look at where the profitability has come from over the last eleven years, but I couldn't without breaking my one idea, one post pledge so, in a spanking new post, here's the DuPont analysis, which breaks profit down into three factors: profit margins (i.e. profits/sales), asset turnover (sales/assets) and the equity multiple (assets/equity):

The three factors multiplied together equal return on equity, and one day I'll write a blog on DuPont analysis and demonstrate that using simple algebra. In the meantime you can check the calculation in my 10 year spreadsheet.

Line 20, Adjusted Return on Equity, is calculated straightforwardly dividing adjusted profit (line 13) by net asset value (line 15) and expressing the result as a percentage, but if I had chosen to multiply lines 16, 17 and 18, the three factors, I'd have got exactly the same answer.

If one or more of the factors rise and the others stay flat, profitability increases. A successful business, gets the first two, which are measures of efficiency, as high as possible, without relying too much on the third because too much leverage is risky.

Colefax's asset turnover (purple bars) is consistently around two meaning it sells fabric and wallpaper of equivalent value to all of the assets it owns roughly every six months (annual sales are twice total assets). The quicker it can turn over its assets, the more money it makes.

Profit margins (green line) are more variable, roughly corresponding to recessions when Colefax might not be able to achieve favourable prices for its products, or costs might be higher, or both. Declines in profit margins explain the declines in profitability at either end of the decade, which I described in the last post.

The most interesting thing for me about this chart is the equity multiple (pink bars), representing leverage, which has steadily declined.

In 2001, net of cash, Colefax owed over ''6m to its bank. In April 2011 its significant liabilities were owed to suppliers and customers. Net of a tiny overdraft Colefax had over ''6m in cash or equivalents stashed away.

Not only is Colefax earning a creditable median 18% return on equity, but these days its doing it without recourse to borrowing, which could juice up returns. I think that's impressive.

Overall the chart depicts a stable business, however, there is a sting in the tail. It implies profit margins have returned to pre-credit crunch levels. That may not persist. A closer look this year's results should reveal more.