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Ratio Analysis is KEY to Understanding Process Decomposition

Blog: Biz-Performance, David Brown

When I was working for the Burroughs Corporation in the early 80’s, I came a across a paper on the DuPont Ratio Analysis. I was intrigued by this method of analysing key ratios and started to use it as a sales tool for justifying the investment in large software products. When targeting a company we would use Dun and Brad Street to obtain the Industry Sector Key Ratio averages and then obtain copies of the annual reports of the prospects and their competitors. Using this information we built a DuPont Ratio Analysis model in a spreadsheet to compare the prospective companies key management ratios with the Industry average and their competitors. Using the spreadsheet model we attempted to demonstrate to the prospect how by improving selected key ratios by the use of our software we could improve their competitive position and justify the investment in the software.
This method of Ratio Analysis is still very effective when using Business Process Management combined with Business Intelligence. When considering a key ratio it is important that it is determined from an end-to-end process that it can be de-composed through lower level processes and their corresponding Key Performance Indicators (KPI’s). This provides a mechanism to assign responsibility and analyse the impact of the ratios changes on the overall performance of the organisation.
The Level 1 key ratio that reflects a measure of operational performance to an organisation is Return on Total Assets (ROTA). The Operating Profit is selected as this is under the direct control of Operational Management within an Organisation. ROTA is an indicator of how effectively a company is using its assets to generate earnings.
ROTA equals Operating Profit (or EBIT) / Total Assets (TA).
Using the DuPont Pyramid Model ROTA can be decomposed to Level 2 ratios by multiplying it by Sales/Sales which is expressed as  EBIT / Sales (or Operating Margin) multiplied by  Sales / TA (or Return on Assets – ROA). The operating profit margin indicates how effective a company is at controlling the costs and expenses of its operations whereas Return on Assets indicates how effectively a business has been making its assets work.
The spreadsheet above shows how the ratios can be further decomposed into operational ratios that can be assigned to departments or individuals. This concept is important when considering the creation of a new, or updating an existing, Profit Formula in Business Modeling.  By generating a spreadsheet or using a planning tool what if scenarios can be created to assist in the modeling of possible outcomes.

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