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Understanding the Du Pont System and Limitations of Ratio Analysis

This chapter explores the Du Pont System, which focuses on expense control, asset utilization, and debt utilization to determine the return on equity (ROE). It also discusses the limitations of ratio analysis and the importance of considering qualitative factors.

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Understanding the Du Pont System and Limitations of Ratio Analysis

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  1. CHAPTER 3 Du Pont system

  2. Topics in Chapter • Du Pont system • Effects of improving ratios • Limitations of ratio analysis • Qualitative factors

  3. Explain the Du Pont System • The Du Pont system focuses on: • Expense control (PM) • Asset utilization (TATO) • Debt utilization (EM) • It shows how these factors combine to determine the ROE.

  4. The Du Pont System ( )( )( ) = ROE Profit margin TA turnover Equity multiplier NI Sales Sales TA TA CE = ROE x x

  5. NI Sales Sales TA TA CE = ROE x x The Du Pont System 2008: 2.6% x 2.3 x 2.2 = 13.2% 2009: -1.6% x 2.0 x 5.2 = -16.6% 2010: 3.6% x 2.0 x 1.8 = 13.0% Ind.: 3.6% x 2.5 x 2.0 = 18.0%

  6. Potential Problems and Limitations of Ratio Analysis • Comparison with industry averages is difficult if the firm operates many different divisions. • Seasonal factors can distort ratios. • Window dressing techniques can make statements and ratios look better. • Different accounting and operating practices can distort comparisons.

  7. Qualitative Factors • There is greater risk if: • revenues tied to a single customer • revenues tied to a single product • reliance on a single supplier? • High percentage of business is generated overseas? • What is the competitive situation? • What products are in the pipeline? • What are the legal and regulatory issues?

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