Dupont Analysis

DuPont Analysis

DuPont analysis is an extended analysis of a company's return on equity. It concludes that a company can earn a high return on equity if:

1. It earns a high net profit margin;
2. It uses its assets effectively to generate more sales; and/or
3. It has a high financial leverage

Formula

According to DuPont analysis:

Return on Equity = Net Profit Margin × Asset Turnover × Financial Leverage
Return on Equity = / Net Income / × / Sales / × / Total Assets
Sales / Total Assets / Total Equity

Analysis

DuPont equation provides a broader picture of the return the company is earning on its equity. It tells where a company's strength lies and where there is a room for improvement.

DuPont equation could be further extended by breaking up net profit margin into EBIT margin, tax burden and interest burden. This five-factor analysis provides an even deeper insight.

ROE = EBIT Margin × Interest Burden × Tax Burden × Asset Turnover × Financial Leverage
Return on Equity = / EBIT / × / EBT / × / Net Income / × / Sales / × / Total Assets
Sales / EBIT / EBT / Total Assets / Total Equity

Example: Three-factor Analysis

Company A and B operate in the same market and are of the same size. Both earn a return of 15% on equity. The following table shows their respective net profit margin, asset turnover and financial leverage.

Company A / Company B
Net Profit Margin / 10% / 10%
Asset Turnover / 1 / 1.5
Financial Leverage / 1.5 / 1

Although both the companies have a return on equity of 15% their underlying strengths and weaknesses are quite opposite. Company B is better than company A in using its assets to generate revenues but it is unable to capitalize this advantage into higher return on equity due to its lower financial leverage. Company A can improve by using its total assets more effectively in generating sales and company B can improve by raising some debt.

The Dupont analysis is a technique that breaks the return on asset and return on equity measures down into basic components that determine profit efficiency, asset efficiency, and leverage in an attempt to help isolate the causes of strengths and weakness in the firm’s performance.

The ROA can be broken down into its components as follows:

1

ROA 'NIAT

Sales

Sales A

1

= (m) (ATO)

The ROA can also be thought of as the product of the profit margin and the asset turnover ratio. This is called the DuPont Equation.

Like ROA we can break ROE down into different components:

1

ROE 'NIAT

Sales

Sale A

1

1

ROE depends on

Efficiency in generating profitsx

from sales

Efficiency in generating salesx

from assets

Amount of assets generated

by each $1 of equity

1

1