9. dupont analysis

7/31/2019 9. Dupont Analysis

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Analysis of Return onStockholders Equity (ROE)


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Uses and Limitation of RatioAnalysis

Du-Pont AnalysisDu-Pont analysis of acompany

Window Dressing


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Ratio Analysis is the most important tool offinancial analysis.

The importance of ratio analysis can besummarized for the various groups:

1. For short term creditors: Liquidity Ratios likecurrent ratio and quick ratio help to

determine the firms ability to meet itsobligations.


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2. For long term creditors: With the help ofsolvency ratios, long term creditors candetermine the firms long term financialstrength and survival.

3. For management: The management candetermine the operating efficiency with

which the firm is utilising its various assestsin generating revenues with the help ofactivity ratios such as capital turnover ratio,etc.


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4. For investors: Profitability ratios like EarningPer Share, Dividend Per Share etc. help todetermine the magnitude and direction of themovements in the firms earning.


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1. Only Quantitative analysis and notQualitative analysis.

2. Comparing ratios over time is complicated by

the fact that economic conditions may changealso.

3. Historical analysis.

4. Not free from bias.


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5. Comparing ratios between two firms is

complicated by the fact that the firms may havedifferent economic environments or productiontechnologies even though they produce thesame product.

6. Reality behind statement to be considered.7. Accuracy of the accounts to be considered.


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A method of performance measurementthat was started by the DuPont Corporationin the 1920s, and has been used by themever since. With this method, companiesanalyze the profitability by usingperformance management tools. To enablethis, DU-PONT model integrates elements

of income statement and balance sheet.


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A type of analysis that examines a company'sReturn on Equity (ROE) by breaking it into threemain components:

Profit margin

Asset turnover and Leverage factor.

By breaking the ROE into distinct parts, investorscan examine how effectively a company is using

equity, since poorly performing components willdrag down the overall figure.


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To calculate a firm's ROE through Du Pontanalysis, multiply the profit margin (netincome divided by sales), asset turnover(sales divided by assets) and leverage factor

(total assets divided by shareholders' equity)together. The higher the result, the higherthe return on equity


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Equity

NIROE


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Equity

AssetsX

Assets

SalesX

Sales

NIROE

Equity

NI

ROE


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XityprofitabilROE

XSales

NIROE

)(


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XefficiencyXityprofitabilROE

XAssets

SalesXSales

NIROE

)()(


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)()()( ipierequitymultXefficiencyXityprofitabilROE

Equity

Assets

XAssets

Sales

XSales

NI

ROE


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)()()( leverageXefficiencyXityprofitabilROE

EquityAssetsX

AssetsSalesX

SalesNIROE


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)()()( leverageXefficiencyXityprofitabilROE

EquityNI

EquityAssetsX

AssetsSalesX

SalesNIROE


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Example:


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Using the DuPont Breakdown


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The Du Pont identity is less useful for someindustries, such as banking, that do not usecertain concepts or for which the conceptsare less meaningful.

Du Pont analysis relies upon the accountingidentity, which are basically not reliable.

Does not include the cost of capital.

Garbage In Garbage Out.


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Window dressing is presenting companyaccounts in a manner which enhances thefinancial position of the company

It is a form of creative accounting involvingthe manipulation of figures to flatter thefinancial position of the business.

The focus of widow dressing:

Hiding the deteriorating liquidity position Camouflaging the profit figures.


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To influence the share price. To reduce liability for taxation.

To encourage investors.

To hide poor management decisions. To satisfy demands of major investors

concerning the level of return.

to hide liquidity problems.

To show a stronger market position thanwarranted.


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Chasing debtorsBringing sales forward

Changing depreciation policyCapital expenditure


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Special efforts to chase the debtors beforethe balance sheet is drawn up.

This might involve discounts for promptpayment.

Conversions of debtors into cash will improvethe balance sheet and cash position of thebusiness.

Liquidity does improve but at the expense ofsales value.


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Sales show up in the P&L account when theorder is received- not when the cash isreceived

Encouraging customers to place order earlier

then the planned, which will improve thesales revenue figure

This can bring sales forward from next year

to this year. The drawback is sales cant be included in the

next years figure


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Increasing the expected life of the asset willreduce the depreciation provision in the profitand loss account.

This will increase the net profit shown in the

account.

Lengthening the expected life boosts profitsshortening it, reduces profits.

It will also mean that the net book value inthe balance sheet will be higher for a longerperiod thereby increasing the firms assetvalue on the balance sheet.


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The distinction between capital expenditureand revenue expenditure is not clear cut.

Computer software with a useful life of 3years.

If treated as a revenue expenditure it istreated as a negative item in P&L account.

If treated as a capital expenditure then it is

treated as a an asset in balance sheet.

9. dupont analysis

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