DuPont analysis (also called the Dupont model or Dupont equation) is a framework used to assess a company’s fundamental performance using the company’s financial statements and financial ratios.
This specific inspection model earns its name from the DuPont Corporation. The company developed this framework to gain clarity about the company’s profitability. It breaks down the profitability ratio, ROE, and analyzes its components individually. This helps investors understand the key drivers of ROE in isolation. It also prevents them from drawing any misleading conclusions about the profitability of the company.
The DuPont analysis takes into consideration the three elements that make up the ROE – the operating efficiency calculated by the net profit margin, financial leverage measured by the equity multiplier, and the efficient asset usage obtained by the asset turnover ratio.
Formula and Calculation of DuPont Analysis
As explained above, the DuPont analysis is a decomposition of the ROE. You can get its value by calculating the product of net profit margin, total asset turnover ratio, and equity multiplier.
Why is DuPont Analysis Important?
DuPont analysis is a convenient tool in evaluating the key drivers of the company’s return on equity. It studies and magnifies the impact made by each component in isolation. The benefits of using DuPont analysis are twofold. It helps understand exactly which financial activity is influencing the return on equity. And it also helps financial managers gauge the strength and shortcomings of the company.
DuPont Analysis Components
DuPont analysis decomposes the return on equity to assess the factors responsible for changing it the most. The three components of DuPont analysis are net profit margin, total asset turnover ratio, and equity multiplier. We’ll look at each of them individually.
Net Profit Margin
The net profit margin evaluates the strength of a company to generate profits per dollar of sales. You can calculate the net profit margin by dividing the net income of the company by its sales (These numbers can be found in the income statement).
A higher net profit margin means that a company is competent in converting its sales into profits and hence improves the ROE. If the return on equity is primarily influenced by net profit margin, it means that the company has a competitive advantage and, as result, can sustain the high ROE.
Total Asset Turnover Ratio
The total asset turnover ratio explains the capability of a company to efficiently use its assets to generate sales. You can calculate the total asset turnover ratio by dividing the total sales of a company by its total assets (Asset numbers can be found in the balance sheet).
A higher total asset turnover ratio shows that the company is more efficient in using its assets to generate sales. Generally, the asset turnover ratio varies from industry to industry, and companies with low-profit margins tend to have high asset turnover, while those with high-profit margins tend to have low asset turnover. However, this ratio can be beneficial while comparing two companies from the same industry. For instance, a change in the total asset turnover ratio might indicate that there is either more increase or decrease in sales than it is being reflected in other financial measures. A higher asset turnover results in a better return on equity.
The equity multiplier calculates the financial leverage of the company. It signifies the portion of the return on equity that results from debt. One can use this analysis by dividing the average total assets of the company by its total shareholders’ equity.
If you have $500 of assets and $200 of equity, this means that the liability is $300 ($500 – $200). Borrowing more to finance the assets will continue to increase the financial leverage. It is useful to use leverage to fund a company’s activities; however, using too much debt can increase the ratio as well as the return on equity.
A higher ROE might be a sign of higher profitability. But if leverage is the primary component affecting it, this means that the expected return on equity is highly uncertain or risky.
Example of Using DuPont Analysis
DuPont analysis is instrumental for investors in comparing the performance of two similar companies. It shows what financial activities are affecting the return on equity the most.
Let’s say an investor is looking to invest in two companies (company A and company B, respectively) within the same industry. Upon monitoring, it seems like both companies are improving their return on equity. But a better choice is the one whose ROE is influenced by an increase in operational efficiency or better use of assets.
The calculation shows that company A improved its profit margin in Year 2 by increasing its net income. It also improved its asset turnover ratio while decreasing its debt.
Company B, on the other hand, had no change in the profit margin and asset turnover ratio over the two years. The key driver of ROE for Company B is the increase in its financial leverage. This is genuinely concerning since it shows that company B borrowed more that resulted in lesser equity. Since there is no change in net income, sales, and profit margin, this means that this leverage is creating no value for the company, and hence the return on equity is also highly uncertain.
DuPont Analysis vs. ROE
The return on equity is calculated by dividing the net income of the company by its total shareholders’ equity. It explains the efficient use of the company’s equity to generate returns.
Conversely, DuPont analysis dives deeper into the equation and explains the relationship between the components of ROE. It helps investors identify the key drivers responsible for the change in return on equity. Financial managers can use this analysis to better understand the strengths and weaknesses of the company.
ROE only gauges a firm’s efficiency in generating profits from its equity. DuPont analysis explains what drives the change in ROE and whether it is favorable at all.
Limitations of DuPont Analysis
As with most financial measures, the biggest drawback of DuPont analysis is that it is an accounting measure. It is prone to manipulations. DuPont analysis is also vague in explaining why individual components are high or low, and if one must perceive it to be high or low. Seasonal factors play a huge role where inventory is high at definite times of the year and may misrepresent the components of DuPont analysis.