THE DUPONT ANALYSIS – CREDIT RISK

In credit risk analysis, a widely used indicator is called DuPont index. Then we'll develop the concept and issues to consider with respect to their usefulness.

Te Dupont analysis (TDA) can be used to illustrate how different factors impact on important financial performance indicators, such as, the return on capital employed (ROCE), the return on assets (ROA), or the return on equity (ROE). These ratios can be calculated by using a simple formula. It is similar to sensitivity analysis, in the sense that the model makes it possible to predict the effect of variability in one or more input variables. The tool is well-known in purchasing management, as it shows the tremendous impact effective purchasing can have on profitability.

The model can be used in several ways. First, it can be used as the basis for benchmarking, comparing different companies in an industry to answer the question of why certain companies realize superior returns compared to their peers. Second, it can be used to predict the effect of possible management actions. TDA will show big differences between industries. If one looks at the ROE, a high score can be caused either by ‘operational efficiency’ or by ‘capital efficiency ´. High turnover industries (e.g. retailers, supermarkets) tend to face low profit margins, high asset turnover and a moderate equity multiplier. Other industries (e.g. fashion, jewelery) depend on high profit margins. In the financial sector, the ROE is determined mainly by high leverage: gaining large profits with relatively low assets. It is essential to choose peers carefully when analyzing how to improve the profitability of a specific company.

We will describe the indicators that make up the formula

ROE =	Profit	/	Equity
Profit margin =	Profit	/	Sales
Asset turnover =	Sales	/	Assets
Equity multiplier =	Assets	/	Equity
ROE =	(Profit margin)	X	(Asset turnover X Equity multiplier)
	OPERATIONAL EFFICIENCY		CAPITAL EFFICIENCY

The following steps have to be performed in a Dupont analysis:

Insert basic information into the model. In particular, identify the information on sales, interest-free liabilities, total costs, equity, current assets and non-current assets.

Calculate the other parameters using the formulas in the figure. This provides you with a basic view of current profitability.

Determine which possible improvements can be made, and how much impact they will have on costs, sales and assets. The effect of a measurement (potential improvements) can be calculated and used as input in the model, whereas the model shows the effect on the ROCE, ROA and ROE.

Compare different potential performance-improving actions with respect to their required investments (time, money and organizational pressure) and their impact on profitability.

Very important, please note it:

This is not a decision – making tool. The comparision of the impact of an improvement action is a first step. Often a detailed analysis to evaluate the possible outcome of potential improvement actions is also required. Do not overlook non-financial issues that are not addressed by this approach.

TDA helps to determine the factors that most influence profitability. However, identifying these factors is only part of the story. The next step is to find appropriate actions that will improve profitability. The balanced score card (including key performance indicators) can also be used to measure a company’s progress regarding critical parameters.

Dupont analysis ought to be used with caution due to this index focuses only on financial parameters. In a credit risk analysis you should be considered 'intangible aspects' (e.g. employee motivation, customers satisfaction, others). These non-financial factors are often very important.

Profesionales Dorbaires

www.dorbaires.com