The DuPont analysis, named after a financial model created by the chemical manufacturer, DuPont Corporation, is a financial framework driven by the return on equity (ROE) ratio. The ROE is used to assess a company’s ability to boost return for its investors.
There are three key components of the ROE ratio that the Dupont analysis is concerned with: net profit margin, asset turnover and equity multiplier. Based on these three, the DuPont model asserts that a company can increase its ROE by boosting profit margins or asset turnover, by or using assets more efficiently.
A typical or acceptable asset turnover ratio depends on the industry. For instance, a small retail business will make much income from its assets with a minimal margin, making the asset turnover ratio quite hefty. In contrast, a utility company has relatively extremely pricey fixed assets with respect to its income, which will lead to a much lower turnover ratio compared to that of the small retail business.
DuPont Analysis FormulaDuPont\: ROE = Net\: Profit\: Margin \times Asset\: Turnover \times Equity\: Multiplier
According to the Dupont model, a company’s ROE is equivalent to the product of its profit margin, asset turnover, and equity multiplier. All the values needed for this calculation can be found on the financial statements or balance sheets.
As indicated in the formula, one of the DuPont analysis components that ROE is separated into is the net profit margin. One of the most basic profitability metrics, this value represents the ratio of a company’s bottom -line profits with respect to its overall revenue or sales.
Imagine a store that sells one item for $2.00. After removing all the costs, such as purchasing inventory, business space rental, employee salaries, taxes, etc., the store owner pockets $0.30 in profit for every sold product, which means the seller’s profit margin is 30% based on the formula above.
This profit margin can still go up if the owner’s costs were minimized or prices were increased, affecting the ROE significantly. This is among the reasons a company’s stock prices become highly volatile when management decides to change its position regarding target margins, costs, prices and the rest.
The second component of ROE that the DuPont analysis involves is the asset turnover ratio. This looks into a company’s efficiency in using its assets to earn income. Picture a company with $200 worth of assets making $2,000 worth of overall revenue in the prior year. The assets drew in 20 times their value in total revenue, which is equivalent to the asset turnover ratio and can be determined with the use of the above formula.
The final component of the DuPont Analysis formula is the equity multiplier. This determines how much of a company’s assets are funded or owned by its shareholders, by comparing its total assets against total shareholder’s equity.
DuPont Analysis Example
Thei is an investor trying to decide between Retailer A and Retailer B, both sports gear manufacturers. She researches their numbers and finds the following data for Retailer A’s profit margin is 30%, asset turnover is 0.50, and equity multiplier is 3. Retailer B’s has a Profit Margin of 15%; Asset Turnover of 6; and Equity Multiplier of 0.50. What are the ROE’s for both retailers and how do they compare?
Let’s break it down to identify the meaning and value of the different variables in this problem.
- DuPont Analysis / Return on Equity (ROE): unknown
- Profit Margin: 30%
- Asset Turnover: .50
- Equity Multiplier: 3
- DuPont Analysis / Return on Equity (ROE): unknown
- Profit Margin: 15%
- Asset Turnover: 6
- Equity Multiplier: .50
Now let’s use our formula:DuPont\: ROE = Net\: Profit\: Margin \times Asset\: Turnover \times Equity\: Multiplier
We can apply the values to our variables and calculate the DuPont Analysis.
Retailer ADuPont\: ROE = 30\% \times 0.50 \times 3 = 45\%
Retailer BDuPont\: ROE = 15\% \times 6 \times 0.50 = 45\%
In this case, Retailer A and Retailer B would have an ROE of 45% each.
Based on the calculation, both retailers have the same ROE, but clearly, their operations are far from the same.
Retailer A is earning more sales while keeping its cost of goods to a minimum, as can be seen by its higher profit margin. The company is finding it hard to turn over huge amounts of sales.
On the other hand, Retailer B is selling at a smaller margin but with a higher product turnover. This is evident in its low profit margin and drastically high asset turnover.
The DuPont Analysis allows investors to compare similar companies with the same ratios, hence allowing them to apply perceived risks with the business model used by each company.
A DuPont analysis is performed to assess the individual components of a company’s ROE, enabling an investor to see which financial activities lead to ROE changes the most. This analysis can be used for comparing two similar companies’ operational efficiency, for example. Managers can rely on DuPont analysis to pinpoint strengths or weaknesses that should be acted upon.
The ratio comes in handy when trying to understand two very similar companies. Since average assets cover things such as inventory, any adjustments in this ratio can be a sign of declining sales or increasing sales that will take some time to manifest in other financial metrics. An increase in a company’s asset turnover means an improvement in its ROE.
The third component of ROE that is considered in the DuPont analysis is equity multiplier, which is also known as financial leverage. It is an indirect look into how a company utilizes debt for funding its assets. Let’s say a company has $2,000 worth of assets with an equity of $500. The balance sheet equation will show that the business also has $1500 in debt. In case the company borrows more money to buy assets, this ratio will increase.
The accounts required to determine the equity multiplier are all on the balance sheet, which means, based on the above formula, average equity will be used to divide average assets instead of the end-period balance.
In most cases, companies must use debt with equity to finance operations and growth. Without using any leverage, the business could lag behind its competitors. Conversely, incurring excessive debt to increase their equity multiplier – and thus their ROE as well – can lead to unbalanced risks.
DuPont Analysis Conclusion
- The DuPont analysis is a model created by the DuPont Corporation and is used to analyze a company’s fundamental performance.
- This formula requires three variables: Net Profit Margin, Asset Turnover, and Equity Multiplier.
- The results of this are usually expressed as a percentage.
- The DuPont analysis dissects the various factors that drive Return on Equity (ROE).
- The DuPont analysis may be used to compare two similar firms’ operational efficiency, as well as define a company’s strengths or weaknesses.
DuPont Analysis Calculator
You can use the DuPont analysis calculator below to quickly calculate a company’s ability to boost return for its investors, by entering the required numbers.