Explain the DuPont System of Financial Analysis.

Answer:

The DuPont methodology (also known as the DuPont model) is a model popularised by the
DuPont Corporation for analysing fundamental results.

DuPont analysis is a useful technique to break down the different components of return on
equity (ROE). The DuPont analysis formula is an expansion of the simple ROE formula. This
expanded formula considers three separate factors that drive return on equity: Net profit
margin, total asset turnover and equity multiplier. Based on these components, the DuPont
model concludes a company can increase its return on equity by maintaining a high-profit
margin, increasing asset turnover and leveraging its assets more effectively.

The DuPont analysis equation is:

DuPont analysis = net profit margin x asset turnover x equity multiplier

Components of the DuPont Equation:

1. 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.

2. 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.

3. Equity Multiplier
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.

The DuPont model can be better understood with the help of following flowchart :

With the help of above flowchart, the DuPont model can be further derived as

DuPont analysis = (net income / revenue) x (sales / average total assets) x (average total
assets / average shareholders' equity)

The DuPont analysis formula is more comprehensive than the simple return on equity formula
because it provides insights into the individual performance markers that drive a company's
ROE. While the simple ROE formula tells us what a company's ROE ratio is, the DuPont
analysis formula tells how much of an impact each individual component has on the company's
ROE ratio.

This makes it possible for financial decision-makers to identify a company's strengths and areas
of opportunity and decide where to make adjustments to increase the business's ROE. Investors
can also use the DuPont model to help them make better-informed investment decisions based
on a detailed comparison of strengths and areas of opportunity for the ROE ratios of similar
companies.

However, the main disadvantage of the DuPont analysis is that it still relies on accounting
equations and data that can be manipulated despite being comprehensive. The DuPont study,
even with its comprehensiveness, lacks meaning as to why the individual ratios are high or low,
or whether they should be considered high or low at all.
Describe the advantages and disadvantages of unsecured borrowings as a source of short
term finance.

Answer :

Unsecured Loan is a loan that doesn't require any type of collateral. Instead of relying on a
borrower's assets as security, lenders approve unsecured loans based on a borrower’s
creditworthiness. Because unsecured loans are not backed by collateral, they are riskier for
lenders. As a result, these loans typically come with higher interest rates.

The three main types of unsecured short-term loans are trade credit, bank loans, and
commercial paper.

1. Trade credit : It is the credit which the seller extends to the buyer between the time
the buyer receives the goods or services and when it pays for them. Trade credit is a
major source of short-term business financing. The buyer enters the credit on its books
as an account payable. In effect, the credit is a short-term loan from the seller to the
buyer of the goods and services.
2. Unsecured Bank Loans : Unsecured bank loans are another source of short-term
business financing. Companies often use these loans to finance seasonal (cyclical)
businesses.
3. Commercial Paper : Commercial paper is an unsecured short-term debt issued by a
financially strong corporation. Many big companies use commercial paper instead of
short-term bank loans because the interest rate on commercial paper is usually 1 to 3
percent below bank rates.

Advantages of Unsecured Sources of Short-Term Financing

Unsecured finance applications are usually quicker and less complex than their secured
equivalents, meaning that capital can often be accessed within a few days. As no assets are
required to take out this type of loan, there is reduced risk for the borrower.

For Lenders of Unsecured Loans:

 The unsecured loans offer high-interest rates and loan processing fees
 They retain customer loyalty
 The loan processing is faster and backed by the borrower’s creditworthiness
 The lenders can move the lien in case of the default
For Borrowers of Unsecured Loans:

 Borrowers do not have to pledge any assets as collateral

 The loan processing is fast
 They can utilize the facility to fund the operational or other business needs without any
covenants attached by the lenders
 Can be used as a revolving credit facility

Lack of access to the financing options and higher cost of equity are the main drivers behind
the unsecured debt financing. For large companies with high creditworthiness, it almost comes
as a readily available option. Banks and other financial institutes have the opportunity of
earning higher interest rates as well as accommodating worthy customers.

Disadvantages of Unsecured Loans

Businesses with weaker trading positions are less likely to qualify, as the decision on whether
to lend is made against indications that repayment will be possible. This decision is more likely
to be in favour of the borrower if a reliable guarantor can be found, but the guarantor's personal
assets are at risk and may be taken if the business that originally borrowed is unable to repay.

Because collateral is not offered, interest rates are usually higher. An unsecured loan without
a guarantor will feature even higher interest rates, as the absence of a guarantee that the loan
will be repaid in case of default means the borrower must further offset the risk.

Unsecured loans possess some other risks for both the borrowers and the lenders:

 Lenders may not be able to recover the full repayment in case of borrower’s default
 Both lenders and borrowers may end up settling the loans with litigation
 Borrowers pay very high-interest rates and transaction fees with unsecured loans
 Lenders may not approve large loan amounts with unsecured loans

Most of the short-term financing takes place as unsecured loans. The borrower’s
creditworthiness plays an important role in the approval of these loans. However, the borrowing
costs and charges along with repercussions can be high for the borrowers.