Financial Analysis with the DuPont Model

The dynamic environment of the world today suggests that one should be apt enough to apply his skills immanent to a system and also external with respect to credit management function. These functions include financial planning, plausibility of a defined business strategy or whether a particular merger or acquisition is feasible or not. This has to be done in a rapid yet meaningful way so as to be of immediate need to a particular firm or investor.

There are basically four major reasons for an effective financial statement analysis. These have been mentioned as follows:

  1. It is useful for long-run business viability so as to determine whether a firm would be able to provide adequate business return when compared to the amount of risks taken. This is essential for outside investors.
  2. It is also used by creditors so as to find out whether a potential buyer has the capability to service the loans that are being made or not.
  3. Also, the analysts concerned about the internal development of a firm, require financial statement analysis so as to monitor the outcome as a result of applying the policy decisions, to make future predictions with regard to the performance targets.
  4. Also make an assessment of the capital needs of a company.

The function of DuPont model in this is that it is used as a tool to provide an overview of financial statement analysis for the purposes as stated and also provide a focus for such analysis. In order to assess the financial health of a firm from the perspective of an insider or an outsider, there are four major areas that are covered. These have been stated as follows:

  1. Liquidity
  2. Leverage
  3. Operational Efficiency
  4. Profitability

In this process, the DuPont model can be used as a compass so as to help the analysts find out the areas that are of significant strength and weakness (as applicable) from the financial statements. DuPont analysis stands as an appropriate place to commence the financial statement analysis as it measures the Return on Equity (ROE). As this indicates the rate of growth of the owners wealth, it becomes one of the most important ratios. So, DuPont analysis might not be able to provide a detailed description just like a proper financial statement analysis, but it certainly stands places in providing an excellent snapshot an impeccable starting point of financial analysis. It covers the major areas of profitability, operating efficiency and also leverage. It can be seen in the form of equations as follows:

ROE = (Net Income/Sales) X (Sales/Average Assets) X (Average Assets/Average Equity)

  • Net Income/Sales: Profitability – This ratio indicates the rate at which a company uses the sales to generate profits for the company. One can see that it has decreased tremendously over a year. This suggests that the company has been trying to lure the customers with better benefits so as to decrease its profits. As the total sales have increased only marginally, it indicates that the market is in a risky position with companies cutting on profits to maintain previous customers and generate new ones.
  • Sales/Average Assets: Total Asset Turnover – Return on Total Assets indicates how well a company has been using its assets to generate sales. It is significant as a company might be generating a huge amount of profit out of sales involved, but then it doesn’t check the efficiency with which it is using the assets for generating the amount of sales involved. In this, case the operating efficiency has decreased which means that the company has either made long-term installations which have not been used to implement sales in the best possible manner or there is a deficiency in the company functioning.
  • Average Assets/Average Equity: Leverage Multiplier – The leverage multiplier is used for determining the debt financing as compared to the equity financing of a company. Generally, if a company increases the debts over equity for financing its requirements, it does it as the cost of debt is less because of tax-deductible interests but then there is a larger risks involved here. A company would have to pay a certain amount for sure before they can make use of the net income.

Further, as the requirement of the company stands, one can also calculate the Return on Assets (ROA) by making a DuPont Chart. This can be done in the following manner:

ROA = (Profit before Income and Tax/ Total Assets) = (PBIT/Sales) X (Sales/ Total Assets)

Application of DuPont Model

There is no doubt that DuPont model will be introduced to find its feasibility. Under the condition of considering the inner link of financial indicators, DuPont model uses the relationship between several major financial ratios to synthetically analyze the financial position of the enterprise. It is a classical method to evaluate the company profitability and shareholders equity returns level and evaluate enterprise performance from a financial perspective. The basic idea of DuPont analysis is to decompose the enterprise net assets yield to the product of a number of financial ratios, thus it can help to make an in-depth analysis of business performance. The most significant feature of DuPont model is to connect several ratios that are used to evaluate corporate efficiency and financial conditions according to their inner links, then form a complete index system, and finally reflect the enterprise by return on equity comprehensively. This method can make the level of financial ratio analysis more clear, organized and outstanding, to provide the operation and profitability of enterprises for financial statement analysts. DuPont model takes related values in place according to their inner links by DuPont chart and the core value is the return on equity. There are three key points that need to be noted when people utilize DuPont model: first, sales net interest rate reflects the relationship of net profit and sales income, and it depends on the sales revenue and total cost. Second, total assets can be referred as an important factor influencing asset turnover ratio and return on equity. Third, equity multiplier is influenced by asset-liability ratio index. To sum up, DuPont analysis system can explain the reason and trend of factor changes.

Though DuPont model has a lot of advantages and it’s widely applied, it also has some limitations. From the perspective of performance evaluation, DuPont model can only show financial information and cannot reflect the strength of enterprise. Primarily, DuPont model focuses on short-term financial results but ignore the long-term value creation. Moreover, financial indicators reflect the enterprise operating performance in the past, to measure industrial enterprises to meet the requirements of the times. But in the current information age, customers, suppliers, employees, technology innovators have more and more influence on the enterprise operating performance, and DuPont analysis is powerless in these aspects. In addition, DuPont model cannot solve the problem of intangible assets valuation that is very important to enhance the competitiveness of enterprises in a long term.

Despite all of these drawbacks, DuPont model are still the most prevalent tactics in enterprises around the world. The main reason is that enterprises nowadays combine classical DuPont analysis theories with the modern financial management goal. Enterprises design new DuPont analysis method based on the combination of the enterprise value maximization goal and the stakeholders’ interest maximization goal. In this way, stakeholders not only include the shareholders of an enterprise, but also consists creditors, business operators, customers, suppliers, employees and government. All these factors are essential for corporate financial management. The damage in either party of enterprise stakeholders’ interest is not conductive to the sustainable development of the company, also not conductive to reach the maximization of enterprise value. In other words, terminal aim of new DuPont analysis is within the framework of law and morality, under the premise of harmonious development, effectively balance the corporate stakeholders’ interest, realize the maximization of enterprise value.

However, factor analysis is feasible in the field that DuPont analysis cannot. Factor analysis is mainly used for determining the influence direction and degree of every factor in the total change in some kind of economic phenomenon affected by many factors. Factor analysis is the application and development of index method principle. It’s based on the index method principle. In the analysis of things change influenced by many factors, in order to observe the effects of some factors change, it will make other factors be fixed, and then analyze and replace item by item, so this method is also known as sequential substitution method. Based on comparative analysis, factor analysis is frequently used to find differences in the process of comparing and fatherly explore the cause. Using factor analysis method, the first step is to study the formation process of the object and find various factors of analysis object; then to compare factors with the corresponding criterion item by item to determine the influence degree of differences of every factors, to help find the main contradiction and indicate the main direction of solving the problem for the next step. For instance, the relationship of a financial value and related factors can be represented as: Actual value: P1= A1xB2xC1; Standard value: P2=A2xB2xC2. The overall variance between the actual value and standard value is P1-P2, and it’s affected by three factors, namely A, B and C. The degree of influence of every factor can be calculated as: Influence of factor A: (A1-A2) xB2xC2; Influence of factor B: A1x (B1-B2) xC2; Influence of factor C: A1xB1x (C1-C2). Plus the above influence value, it is the overall variance: P1-P2. From the above analysis, it can be seen that factor analysis can be used for the detailed analysis of the degree of influence and can be more beneficial to guide the decision makers to find financial issues and propose solutions.

In conclusion, DuPont analysis and factor analysis have their own range of application. Through DuPont analysis system can provide better reasons and trends of financial index changes, factor analysis is better in enterprises’ financial analysis. Factor analysis can be used for more detailed analysis of the degree of influence and can be more beneficial to guide the decision makers to find financial issues ultimately and propose solutions fundamentally. In sum, factor analysis method has more extensive scope of application.

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