Question

1. When does DuPont analysis becomes unreliable? Explain.

2. What are the drawbacks to using DuPont analysis?

Answer 1

Dupont Analysis is a widely used financial model to decompose the Return on Equity equation into three different parts to gain a deeper understanding of the financial position of the companty. Mainly the Dupont model is divided in three parts that is -:

1) Return on Sales: Net Income/Sales

2) Asset Turnover: Sales/Assets

3) Financial Leverage: Assets/Equity

The reliability of the dupont analysis depends on the reliability of the data. If the data is fudged then the analyis will not accurately represent the financial position of the company. Secondly the notion of comparibility of the data will depend if the industry at large also has relevance. Other companies also need to practice similarly for us to accurately compare. Lastly, Different accounting practices between companies can also make accurate comparisons difficult.

Drawbacks: One major drawback of the dupont method is that it does not include the cost of capital . The cost of capital inculcates risk in any financial project. Without the inclusion of the risk element Dupont Analysis is just an exercise in accounting. An accurate financial decision can never be made without considering risk, return which Dupont Analysis fails to account for. As a result Dupont Analysis can also be used as accounting window dressing and not an accurate financial tool.

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