Course Code: 3.3.

Business Valuation and Value Base Management

Du-Pont Analysis

DuPont analysis is a multi-step financial equation that provides insight into a business’s
fundamental performance. The DuPont model provides a thorough analysis of the key metrics
impacting a company’s return on equity (ROE). Another term for the DuPont analysis is the
DuPont model. These names originate from the DuPont Corporation of USA, the company that
created the model in 1920.

The DuPont analysis formula is an expansion of the simple ROE formula. This expanded
formula considers three separate factors that drive return on equity: Net profit margin, total
asset turnover and equity multiplier. Based on these components, the DuPont model concludes
a company can increase its return on equity by maintaining a high profit margin, increasing
asset turnover and leveraging its assets more effectively. The DuPont analysis equation is:

DuPont Analysis = Net Profit Margin × Asset Turnover × Equity Multiplier

Each of these factors represents the result of a separate formula. When you replace the factors
in the DuPont analysis equation with the formulas that make up each component, the DuPont
analysis equation looks like this:

DuPont Analysis = (Net Income ÷ Revenue) × (Sales ÷ Average Total Assets) × (Average Total
Assets ÷ Average Shareholders’ Equity)

The DuPont equation is less useful for some industries, that do not use certain concepts or for
which the concepts are less meaningful. On the other hand, some industries may rely on a single
factor of the DuPont equation more than others. Thus, the equation allows analysts to determine
which of the factors is dominant in relation to a company’s return on equity. For example,
certain types of high turnover industries, such as retail stores, may have very low profit margins
on sales and relatively low financial leverage. In industries such as these, the measure of asset
turnover is much more important.

High margin industries, on the other hand, such as fashion, may derive a substantial portion of
their competitive advantage from selling at a higher margin. For high end fashion and other
luxury brands, increasing sales without sacrificing margin may be critical. Finally, some
industries, such as those in the financial sector, chiefly rely on high leverage to generate an
acceptable return on equity. While a high level of leverage could be seen as too risky from
some perspectives, DuPont analysis enables third parties to compare that leverage with other
financial elements that can determine a company’s return on equity.

DuPont Analysis Components

DuPont analysis breaks ROE into its constituent components to determine which of these
components is most responsible for changes in ROE.
Net margin: Expressed as a percentage, net margin is the revenue that remains after subtracting
all operating expenses, taxes, interest and preferred stock dividends from a company's total
revenue.

Asset turnover ratio: This ratio is an efficiency measurement used to determine how
effectively a company uses its assets to generate revenue. The formula for calculating asset
turnover ratio is total revenue divided by total assets. As a general rule, the higher the resulting
number, the better the company is performing.

Equity multiplier: This ratio measures financial leverage. By comparing total assets to total
stockholders' equity, the equity multiplier indicates whether a company finances the purchase
of assets primarily through debt or equity.

The higher the equity multiplier, the more leveraged the company, or the more debt it has in
relation to its total assets.

Significance of Du Pont Analysis:

The DuPont Analysis is important determines what is driving a company's ROE; Profit
margin shows the operating efficiency, asset turnover shows the asset use efficiency,
and leverage factor shows how much leverage is being used. The method goes beyond profit
margin to understand how efficiently a company's assets generate sales or cash and how well
a company uses debt to produce incremental returns.

Using these three factors, a DuPont analysis allows analysts to dissect a company, efficiently
determine where the company is weak and strong and quickly know what areas of the business
to look at (i.e., inventory management, debt structure, margins) for more answers. The measure
is still broad, however, and is not a substitute for detailed analysis.

The DuPont analysis looks uses both the income statement as well as the balance sheet to
perform the examination. As a result, major asset purchases, acquisitions, or other significant
changes can distort the ROE calculation. Many analysts use average assets and
shareholders' equity to mitigate this distortion, although that approach assumes the balance
sheet changes occurred steadily over the course of the year, which may not be accurate either.

Again, this model was developed to analyse ROE and the effects different business
performance measures have on this ratio. So investors are not looking for large or small output
numbers from this model. Instead, they are looking to analyse what is causing the current ROE.
For instance, if investors are unsatisfied with a low ROE, the management can use this formula
to pinpoint the problem area whether it is a lower profit margin, asset turnover, or poor financial
leveraging. Once the problem area is found, management can attempt to correct it or address it
with shareholders. Some normal operations lower ROE naturally and are not a reason for
investors to be alarmed. For instance, accelerated depreciation artificially lowers ROE in the
beginning periods.
Limitations of Ratios Analysis

Ratio analysis is a widely used and useful technique to evaluate the financial position and
performance of any business unit but it suffers from a number of limitations. These limitations
must be kept in mind by the analyst while using this technique.

a) Reliability is Linked with Accounting Data:

Ratios are calculated on the basis of accounting information. Accounting system has certain in
built limitations like historical cost, going concern value, stable monetary value, etc. So,
limitations of accounting data affect the quality of ratios also. After, all ratios can’t be more
reliable than the reliability of data itself.

b) Qualitative Factors are Ignored:

Ratio analysis is only a quantitative analysis. Sometimes qualitative factors may be important.
For example, management may be justified in making huge purchases of raw material in
anticipation of large demand of its product for the coming period. But ratios are not capable of
considering qualitative factors.

c) Isolated Ratios is Meaningless:

Ratios assume significance only when studied in proper context and if compared with norms
or over a period. Ratio in itself does not convey any sense.

d) Ratio Analysis is Historical:

Ratios are based on the facts contained in financial statements. These statements contain past
records. Past may be less important or irrelevant for the management than present and future.

e) Different Accounting Practice Render Ratios Incomparable:

Accounting permits alternative treatment of many items like depreciation, valuation of stock,
deferred expenses etc. Ratios based on statements prepared by following different practices are
not comparable.

f) Price Level Changes Affect the Utility of Ratio Analysis:

Comparison of ratios over a period of time relating to same unit may be misleading. For
example, sales may be static in quantity but higher in dollar value due to inflation.

g) Incompetence or Bias of Analyst:

Much depends upon the skill, integrity and competence of the analyst to use ratios judiciously.

h) Lack of Adequate Standards:

i) Window Dressing:

Financial statements can easily be “window dressed” to depict better than real picture of the
enterprise. Moreover the analyst depending only upon published financial statements will not
be in a position to get inside information.

Problem:

1. XYZ Company’s details are as under: Revenue: Rs. 29,261; Net Income: Rs. 4,212;
Assets: Rs. 27,987; Shareholders’ Equity: Rs. 13,572. Calculate return on equity.

2. Given the following financial data on a company, what is the company’s ROE? Net
income Rs. 50,000; Revenue Rs. 2,85,000; Average total assets Rs. 1,000,000; Average
shareholder’s equity 600,000.

3. The following financial statements have been extracted from the Annual Report 2016-
17 of METCALF TEXTILES Ltd. a largest Textile Company, having a strong presence
in over 80 countries in the world.

The company wants to keep its shareholders happy by giving them a fair rate of return.
The company is using return on equity (ROE) as one of the metrics of performance
evaluation for determining the return for shareholders. Due to intense competition, in
recent years, its ROE is under pressure and to maintain the level of ROE, the company
is to change its business Model-in that, it is varying its, margin, assets utilization and
leverage.

You are required to:

(i) Carryout the DuPont Analysis considering the financial parameters given below
and show how the return on equity (ROE) of the company (Metcalf Textiles
Ltd.) is changing due to change in its Margins, Assets utilization and Leverage
over the period of four years.
(ii) Give your comments on the trend of the said parameters.