FM&BV

Unit 1 (2 theory, 1 Sums) Sums: Dupont Analysis

Theory:

1. Explain the various components of Dupont Analysis.

The DuPont Equation The DuPont equation is an expression which breaks return on equity down into
three parts: profit margin, asset turnover, and leverage.

The DuPont equation is an expression which breaks return on equity down into three parts. The

name comes from the DuPont Corporation, which created and implemented this formula into

their business operations in the 1920s. This formula is known by many other names, including

DuPont analysis, DuPont identity, the DuPont model, the DuPont method, or the strategic profit

model. The DuPont Equation:

In the DuPont equation, ROE is equal to profit margin multiplied by

asset turnover multiplied by financial leverage.

Under DuPont analysis, return on equity is equal to the profit margin multiplied by asset turnover

multiplied by financial leverage. By splitting ROE (return on equity) into three parts, companies

can more easily understand changes in their ROE over time.

Components of the DuPont Equation: Profit Margin

Profit margin is a measure of profitability. It is an indicator of a company’s pricing strategies and

how well the company controls costs. Profit margin is calculated by finding the net profit as a

percentage of the total revenue. As one feature of the DuPont equation, if the profit margin of a

company increases, every sale will bring more money to a company’s bottom line, resulting in a

higher overall return on equity.

Components of the DuPont Equation: Asset Turnover

Asset turnover is a financial ratio that measures how efficiently a company uses its assets to

generate sales revenue or sales income for the company. Companies with low profit margins tend

to have high asset turnover, while those with high profit margins tend to have low asset turnover.

Similar to profit margin, if asset turnover increases, a company will generate more sales per asset

owned, once again resulting in a higher overall return on equity.

Components of the DuPont Equation: Financial Leverage

Financial leverage refers to the amount of debt that a company utilizes to finance its operations,

as compared with the amount of equity that the company utilizes. As was the case with asset

turnover and profit margin, Increased financial leverage will also lead to an increase in return on

equity. This is because the increased use of debt as financing will cause a company to have

higher interest payments, which are tax deductible. Because dividend payments are not tax

deductible, maintaining a high proportion of debt in a company’s capital structure leads to a

higher return on equity.

2. EXPLAIN THE STEPS FOR BUILDING A FINANCIAL MODEL.

Process Steps
The financial modeling process involves the following steps to ensure effectiveness. Let us look
into these steps in details below:
 The entry of Historical Financial Data
 Analysis of Historical Performance
 Gathering of Assumptions for Forecasting
 Forecast the Three Statement Model
 Future Business Risk Assessment
 Performance of Sensitivity Analysis
 Stress Testing of the Forecast
#1 – Entry of Historical Financial Data
Any financial model starts with the entry of historical financial statements. The analyst then
inputs the historical information into an excel spreadsheet, which marks the start of financial
modeling. Generally, analysts prefer the latest 3 to 5 years of historical data as it provides a fair
bit of insight into the company’s business trend in the recent past. The analyst should be
cautious while capturing the historical data from the three financial statements and the
corresponding schedules. Any mistake in this step can potentially deteriorate the quality of the
end model.
#2 – Analysis of Historical Performance
In this step, the analyst must apply all their knowledge of accounting and finance. Each line item
of the historical income statement, balance sheet and cash flow statement should be analyzed
to draw meaningful insights and identify trends. For instance, growing revenue, declining
profitability, deteriorating capital structure etc.
It is important to note that this analysis will strongly influence the assumptions for forecasting.
Once the trend has been identified, the analyst should try and understand the underlying
factors driving the trend. For instance, the revenue has been growing due to volume growth;
the profitability has been declining in the last three years owing to a surge in raw material
prices; capital structure has deteriorated on the back of debt-laden capex plan etc.

#3 – Gathering of Assumptions for Forecasting

Next, the analyst has to build the assumptions for the forecast. The first method to draw
assumptions is using the available historical information and their trends to project future
performance. For instance, forecast the revenue growth as an average of the historical revenue
growth in the last three years, project the gross margin as an average of the historical period,
etc. This method is useful in the case of stable companies.
On the other hand, some analysts prefer to use forecast assumptions based on the current
market scenario. This approach is more relevant in the case of companies operating in a cyclical
industry, or the entity has a limited track record. Nevertheless, the assumptions for some of the
line items in the balance sheet, such as debt and CAPEX, should be drawn from the guidance
provided by the company to build a reliable model.

#4 – Forecast the Financial Statements using the Assumptions

Once the assumption is decided, it is time to build the future income statement and balance
sheet based on the assumptions. After that, the cash flow statement is linked to the income
statement and balance sheet to capture the cash movement in the forecasted period. At the
end of this step, there are two basic checks –
 The value of the total asset should match with the summation of total liabilities and
shareholder’s equity
 The cash balance at the end of the cash flow statement should be equal to the cash
balance in the balance sheet
#5 – Future Business Risk Assessment
Next, the analyst should create a summary of the output of the final financial model. The output
is usually customized as per the requirement of the end-user. Nevertheless, the analyst must
provide their opinion on how the business is expected to behave in the upcoming years based
on the financial model. For instance, the analyst can comment that the company will be able to
grow sustainably and service its debt obligations without any real risks in the near to medium
term.
#6 – Performance of Sensitivity Analysis
This step aims to determine at what point the performance of the company will start to decline
and to what extent. In this step, the analyst must build scenarios into the model to perform
sensitivity analysis. In other words, the resilience of the business model will be tested based on
scenarios. This step is beneficial as it helps assess variation in performance in case of an
unanticipated event.

#7 – Stress Testing of the Forecast

Here the analyst assumes the worst-case (extreme) scenario based on some unfortunate event
during a specific period, say a decade. For instance, the recession of 2008-09 is used for stress
testing the forecasting models of US-based companies. This step is also crucial as it helps
understand how a company will behave in such an extreme scenario and whether it can sustain
itself.
3. IMPORTANCE OF FINANCIAL MODELING.

Following this financial modeling process step-by-step and then preparing a spreadsheet is, of course, a
time consuming affair, but once the standard format is prepared, entering, organizing, and managing
data becomes easier. However, there are financial modeling templates available to save one’s time. It
offers an in-built format to store, and use data from.

No matter which format one uses, manual or system-built, the organized data is of great importance. Let
us have a quick look at some of them below:

It helps give a clear picture of expenses and earnings a business has.

Knowing the difference helps businesses assess the real position of the business. In turn, the firms
also know how the stock performance would be.

The figures become a ready reference for investors, who many have a look at it to decide whether
making investments in the assets would be fruitful.

The businesses, through this spreadsheet or template information, get to know how effective the
strategies implemented for business growth have been. If they are found working well, the firms
continue with the same. Else, they modify the strategies for better results.

As the businesses learn about the expenses, they may make smart asset allocation and cost
management decisions, accordingly.

4. EXPLAIN THE APPLICATION OF DUPONT ANALYSIS.

 DuPont Analysis, using three vital parameters of a business’s growth and sustainability, highlights
the strengths of a business and at the same time points out any weakness present. For Example,
a business with high profit margins may look like a great investment, but if it has used excessive
 leverage (that is, it has lot of debt on its books), it may land into trouble if margins start to
shrink, as the business has to keep paying its debt obligations, irrespective of whether it makes a
profit or suffers a loss.

 DuPont analysis can also be used to find the exact pain points of the business. For Example, if a
business has low ROE, you can find the area where it is lagging behind, is it excessive leverage or
poor asset turnover? By understanding the exact issues, you can wait for things to get better in
the future, and when things start to improve, you can make a decision to invest.

 DuPont Analysis can also be used to compare two or more similar businesses, helping you find
which one is better. For Example, let’s say there are two companies, A and B, both of them have
same Net Profit Margin of 15%, making it difficult for you to understand, which one is better. In
order to make a clear decision, you need to look at the other components of DuPont Analysis
such as leverage. If company A has a leverage ratio of 0.5 and Company B has a leverage ratio of
1.2, it clearly shows that Company B has higher leverage, making it a riskier investment
compared to Company A.

5. WHAT IS DUPONT ANALYSIS AND IT'S DRAWBACKS.

DuPont Analysis, using three vital parameters of a business’s growth and sustainability, highlights the
strengths of a business and at the same time points out any weakness present. For Example, a business
with high profit margins may look like a great investment, but if it has used excessive leverage (that is, it
has lot of debt on its books), it may land into trouble if margins start to shrink, as the business has to
keep paying its debt obligations, irrespective of whether it makes a profit or suffers a loss.

DuPont analysis can also be used to find the exact pain points of the business. For Example, if a business
has low ROE, you can find the area where it is lagging behind, is it excessive leverage or poor asset
turnover? By understanding the exact issues, you can wait for things to get better in the future, and
when things start to improve, you can make a decision to invest.

DuPont Analysis can also be used to compare two or more similar businesses, helping you find which one
is better. For Example, let’s say there are two companies, A and B, both of them have same Net Profit
Margin of 15%, making it difficult for you to understand, which one is better. In order to make a clear
decision, you need to look at the other components of DuPont Analysis such as leverage. If company A
has a leverage ratio of 0.5 and Company B has a leverage ratio of 1.2, it clearly shows that Company B
has higher leverage, making it a riskier investment compared to Company A.

Pitfalls of DuPont Analysis:

Just like every other fundamental analysis model, DuPont Analysis also has some drawbacks which

should be kept in mind while analyzing a business.

Some of the major pitfalls of DuPont Analysis are as follows:

It’s not suitable for absolute valuation:

Not exactly a drawback, but this definitely is a limitation. DuPont Analysis is used to compare two or
more similar companies to find which one has better quality fundamentals. It cannot be used for
absolute or standalone analysis of a company.

Does not take consider Valuation as a parameter:

No matter how good a company is, if you pay too much for it, it does not make a good investment.

While DuPont analysis is a great tool for analyzing the quality of a business, it does not take into account

how cheap or expensive a company is in terms of valuation and if it is the right price to buy the stock.

Does not work for asset-light business models:

DuPont Analysis uses asset turnover as one of the parameters for analyzing the quality of a company,

which can be crucial for many asset heavy businesses such as the ones engaged in manufacturing, power

generation, Iron and steel etc.

main disadvantage of the DuPont model is that it relies heavily on accounting data from a company's
financial statements, some of which can be manipulated by companies, so they may not be accurate.

However, DuPont analysis may not be very useful for analyzing asset light businesses, such as IT, and new

age online businesses, as almost all of them have very little assets but still generate large revenue.

Unit 2 ( 1 theory, 3 sums) Sums: Time value of money, cost of capital, leverage.

Theory:

1. Explain the different types of leverage with formula and interpretation.

2. Explain the concept of peer to peer analysis in financial modelling.

3. Explain the ratio to be consider in peer group analysis.

Unit 3 (1 theory, 2 sums)

Sums: Wacc, Ratio Analysis

Theory:

1. Explain Cash flow from operating/financial/investing.

Unit 4 (1 theory, 2 sums)

Sums: Valuation of goodwill

Theory:

1. Explain the factors to consider for valuation of assets.

2. Explain the super profit method of valuing goodwill.

3. What is the purpose of business valuation.