Shareholders of all firms want to achieve sustainable high return on equity (ROE) and even though the drivers will be very different, visualizing operating profits and cash flows as well as the required (or available) capital structure in a systematic way can be useful to better understand the creation of value.
Start-ups may initially have to ignore KPIs on profitability and cost efficiency in order to enter new markets fast enough and take risks. However, when start-ups become grown-ups they need to professionalize their financial and cash management.
Entrepreneurs need to know how a profitable cash flow positive business model will look like and start to implement it in their organizations. Ultimately company valuations are based on long term cash flows that are distributed to shareholders so it is critical to identify the drivers of those cash flows regardless of the business model or product.
A classical analytical tool for mature companies is the DuPont formula. Developed in the 1920s by the DuPont Corporation it was enhanced and developed further. Later concepts like the Balanced Scorecard tried to overcome the critique that a myopic view on financial indicators leaves out important aspects of a firm´s business such as customer needs or its vision. The original structure, however, is a good start to financial analysis.
The DuPont formula is based on accounting figures and connects the lines in the financial statement to obtain basic KPIs like gross margin, EBIT and profit margin as well as mixed ratios like asset turnover and return on capital combining the p&l and balance sheet figures. It is a top down approach to analyze existing operations.
Chart: DuPont Model, own graphical representation
As with all ratios, the KPIs are only meaningful in the context of their relevant industry, business model and company life cycle stage. In order to derive a strategy and operational targets the ratios must be drilled down to industry specific and company or business model specific KPIs.
For example, a diversified industrial corporation owning R&D, production and distribution units will have a large share of tangible fixed assets, long term debt, interest expenses and a return on equity more dependent on the cost of debt and financial leverage than on revenue growth. In fact, for a multinational, like Siemens AG for example, the DuPont formula would be applied to each business unit separately in order to draw the right conclusions about operating efficiency.
In a small but growing Software-as-a-Service company we would most likely see very little tangible assets, low bank debt, maybe negative working capital and high fixed costs for marketing and customer acquisition. The drivers for return on equity are revenue growth (drilled down to the number of customers, customer lifetime value, monthly recurring revenue, customer acquisition costs and churn) and gross margin, i.e. the operational leverage.
Today, production or infrastructure assets and operations are often separated and companies are specializing in different stages of the value chain. The companies owning the assets have access to debt financing using their tangible assets as collateral. Operating companies need much lower investment to start the business but may find it hard to secure debt financing for their expansion plans due to a lack of collateral. They therefore require much higher margins to achieve the required ROE.
Digital businesses typically invest in software development and create intangible assets which are not accepted as loan collateral by banks. These companies have to rely on equity financing for their investment in long-term fixed assets in the early stage and once they are on the market also face the lack of financing typical for operating companies. Financing a scale-up with equity capital would then mean continued dilution of the founders` share in the company.
Continue at: http://round2lab.com/2017/08/04/how-to-financial-analysis-using-the-dupont-formula/
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