what is DuPont analysis
16 Oct 06
What is the DuPont Model? Description The DuPont Model is a technique that can be used to analyze the profitability of a company using traditional performance management tools. To enable this, the DuPont model integrates elements of the Income Statement with those of the Balance Sheet. Origin of the DuPont Model. History The DuPont model of financial analysis was made by F. Donaldson Brown, an electrical engineer who joined the giant chemical company's Treasury department in 1914. A few years later, DuPont bought 23 percent of the stock of General Motors Corp. and gave Brown the task of cleaning up the car maker's tangled finances. This was perhaps the first large-scale reengineering effort in the USA. Much of the credit for GM's ascension afterward belongs to the planning and control systems of Brown, according to Alfred Sloan, GM's former chairman. Ensuing success launched the DuPont model towards prominence in all major U.S. corporations. It remained the dominant form of financial analysis until the 1970s. Calculation of DuPont. Formula Return on Assets = Net Profit Margin x Total Assets Turnover = Net Operating Profit After Taxes / Sales x Sales / Average Net Assets Usage of the DuPont Framework. Applications The model can be used by the purchasing department or by the sales department to examine or demonstrate why a given ROA was earned. Compare a firm with its colleagues. Analyze changes over time. Teach people a basic understanding how they can have an impact on the company results. Show the impact of professionalizing the purchasing function. Steps in the DuPont Method. Process Collect the business numbers (from the finance department). Calculate (use a spreadsheet). Draw conclusions. If the conclusions seem unrealistic, check the numbers and recalculate. Strengths of the DuPont Model. Benefits Simplicity. A very good tool to teach people a basic understanding how they can have an impact on results. Can be easily linked to compensation schemes. Can be used to convince management that certain steps have to be taken to professionalize the purchasing or sales function. Sometimes it is better to look into your own organization first. In stead of looking for company takeovers in order to compensate lack of profitability by increasing turnover and trying to achieve synergy. Limitations of the DuPont analysis. Disadvantages Based on accounting numbers, which are basically not reliable. Does not include the Cost of Capital. Garbage in, garbage out. Assumptions of the DuPont method. Conditions Accounting numbers are reliable. Financial analysis with the DuPont ratio: A useful compass In today's dynamic business environment, it is important for credit professionals to be prepared to apply their skills both within and outside the specific credit management function. Credit executives may be called upon to provide insights regarding issues such as strategic financial planning, measuring the success of a business strategy or determining the viability of an acquisition candidate. Even so, the normal duties involved in credit assessment and management call for the credit manager to be equipped to conduct financial analysis in a rapid and meaningful way. Financial statement analysis is employed for a variety of reasons. Outside investors are seeking information as to the long run viability of a business and its prospects for providing an adequate return in consideration of the risks being taken. Creditors desire to know whether a potential borrower or customer can service loans being made. Internal analysts and management utilize financial statement analysis as a means to monitor the outcome of policy decisions, predict future performance targets, develop investment strategies, and assess capital needs. As the role of the credit manager is expanded cross-functionally, he or she may be required to answer the call to conduct financial statement analysis under any of these circumstances. The DuPont ratio is a useful tool in providing both an overview and a focus for such analysis. A comprehensive financial statement analysis will provide insights as to a firm's performance and/or standing in the areas of liquidity, leverage, operating efficiency and profitability. A complete analysis will involve both time series and cross-sectional perspectives. Time series analysis will examine trends using the firm's own performance as a benchmark. Cross sectional analysis will augment the process by using external performance benchmarks for comparison purposes. Every meaningful analysis will begin with a qualitative inquiry as to the strategy and policies of the subject company, creating a context for the investigation. Next, goals and objectives of the analysis will be established, providing a basis for interpreting the results. The DuPont ratio can be used as a compass in this process by directing the analyst toward significant areas of strength and weakness evident in the financial statements.