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ACC501 Business Finance GDB Solution Fall 2013

The DuPont identity or model of financial statement analysis was developed by F. Donaldson Brown. He joined the huge chemical company’s reserves department in 1914 and then he developed a model for planning and controlling inventories. Afterwards, this model was used frequently for financial statement analysis as well. It is claimed that Du Pont analysis is the best analysis, which can be used for the measurement of overall performance of financial statements of any firm.

There are two different opinions regarding the application of Du Pont model. One of them states that it is not the best tool for analyzing financial statements while the other considers this model as the best one for the said purpose.

As a student of “Business Finance”, which of the above mentioned opinions you would support? Whether Du Pont Model is the best technique for the financial statement analysis or not? Support your arguments with conceptual rationale in either case.

Solution: 

DuPont analysis is an excellent method to determine the strengths and weaknesses of a farm.

Fundamentally, for any business there are two primary ways to enhance operating performance as measured by return on assets:

  • Increase operating profit margins, and
  • Increase gross revenues per dollar invested or capital turnover.

Operating performance can be augmented through the use of debt or leverage to generate the ultimate performance measure for the individual investor – return on investment equity. These are expressed in the DuPont equation as follows:

Return on Equity = Asset Turnover x Net Profit Margin x Leverage

 

The Du Pont Identity

The Du Pont identity tells us that ROE is affected by three things:

  1. Operating efficiency (as measured by profit margin)
  2. Asset use efficiency (as measured by total assets turnover)
  3.  Financial Leverage (as measured by equity multiplier)

 

Considering the Du Pont identity,

  1. It appears that a firm could leverage up its ROE by increasing its amount of debt
  2. This will only happen if ROA exceeds interest rate on debt.

 

The Du Pont Identity

 

  1. The decomposition of ROE is a convenient way of systematically approaching the financial statements analysis.
  2. If ROE is unsatisfactory by some measure, then Du Pont identity tells you where to start looking for the reasons.

 

Why DuPont Financial Analysis is Important

Fundamentally, any decision that influences product prices, per unit costs, volume or efficiency / productivity (output per unit of input) will impact profit margin or turnover ratio.  And any decision that affects the amount and type of debt and equity used will impact the financial structure as well as cost.

These financial concepts are important to understand because every business in the world is competing for capital.  Money flows where the perceived risk adjusted return is greatest.  If we as marketers of products and services to businesses understand these financial concepts, we can better understand where we might be able to help our customers the most.  We need to understand how we deliver value to our business customers.

Marketing value involves much more than a pep rally/sales meeting rah-rah. It’s a culture … a mindset, a strategy. To do it well, you first need to be able to define it. Understanding the financial concepts allow you to focus on the key questions you should answer to help define your value.

How do you or how can you help your customers:

  1. Increase the price per unit of product they sell by adding new features and benefits to their products, services, and systems
  2. Decrease the variable cost to produce, acquire or sell the unit.
  3. Increase the number of units sold
  4. Decrease the overhead by increasing their efficiency of operations
  5. Increase asset turnover by
  6. Minimizing the customer’s work in process or finished goods inventory (and therefore total assets)
  7.  Decreasing fixed assets by outsourcing some processes, enabling some capital assets to be sold

To truly add value and set yourself apart from the competition, you need to know how to help your customers

  • Control one or more of their critical costs or
  • Exploit one or more of their critical revenue sources.

Ask yourself these two key questions about what you sell, and your opportunities to add value to your customers will increase dramatically.

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