Using the DuPont Analysis as an indicator of the viability of a company's business model

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It has been encouraging to have started 2018 with a positive assessment of the
economic environment, which is reflected in this comment in the IMF World Economic
Outlook Update, January 2018
https://www.imf.org/en/Publications/WEO/Issues/2018/01/11/world-economic-outlook-
update-january-2018
“Global economic activity continues to firm up. Global output is estimated to have grown by
3.7 percent in 2017, which is 0.1 percentage point faster than projected in the fall and ½
percentage point higher than in 2016. The pickup in growth has been broad based, with
notable upside surprises in Europe and Asia…”
Other indicators, such as unemployment trends, have been positive too.
There are however challenges, as the IMF World Economic Outlook Update, January 2018
states
“Brighter Prospects, Optimistic Markets, Challenges
Ahead”
The widely reported severe financial difficulties of Carillion, a major UK construction
and related services company has been a reminder that the business environment has
not been easy for some major businesses.
Each company has its own features, but are there some general lessons we can learn
from Carillion’s problems?
Carillion isn’t the first contracting firm to face financial difficulties, nor will it be the last.
A ratio that is often used in financial analysis is the DuPont Analysis (or Return on Equity)
ratio. It is a ratio derived from the DuPont ratio that was initially developed more than 100
years ago. Like all ratios it has limitations such as not taking into account off balance sheet
risks…both financial and operating (I also prefer using market values for a company and
recent asset values should be used when interpreting the ratio to give a more accurate
representation of returns, and accounting measures can always be distorted to a greater

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extent than cashflow based measures). However, the DuPont Analysis has great value, in my
opinion, in analysing a company’s business model, as the three components are
1. An efficiency ratio (sales / Average Total Assets)
2. A financial structure ratio (assets /equity)
3. A profitability ratio (net income / sales)
Looking at Carillion and the construction industry in broader terms, the business model is often
characterised by
• Low profit margins
• Relative to many other industries, high sales in relation to assets
• A capital structure that is often quite highly leveraged
In the case of construction companies, they also face substantial operating risks so the
operating leverage is high.
The result of low profit margins, high sales turnover in relation to assets and the capital base,
combined with high financial and operating leverage means that there is limited ability to
absorb either sudden or ongoing adverse changes in business conditions (such as cost
overruns being experienced by Carillion). Financial difficulties follow!
What other industries are potentially vulnerable when considering the components of
the DuPont Analysis?
A number of industries face disruptive market conditions. Companies operating with low profit
margins, overtrading in relation to their capital base and with high financial and operating
leverage are particularly vulnerable.
In recent months, examples of companies facing difficulties are Steinhoff (high growth in a
retailing sector that is facing pressure as a result of on line retailing), and Noble Group (a
commodity trading and processing company which is in the process of a financial
restructuring). Both are in industries characterised by relatively low operating margins which
have faced significant adverse changes in the business environment and where major
acquisitions have been made.
Hopefully the positive comments in the IMF World Economic Outlook update about Global
Economic Activity firming up will prove to be reality as 2018 progresses, but as the collapse
of Carillion and challenges facing Steinhoff and Noble Group show, businesses operating with
high asset turnover, low margins and high financial and operating leverage, particularly in
industries undergoing significant change and with major operating risks, are highly vulnerable
to adverse changes in the business environment.