It is an approach for computing return on equity (ROE) encompassing a broad level of indicators leading to this return. DuPont analysis calculator calculates this ROE using three different factors. These factors include operating efficiency, the efficiency of assets in generating revenues, and the efficiency of assets in earning for shareholders’ funds. So, it is a combination of Operating performance, resource utilization (assets use), and deployment of funds.
Return on equity (ROE) is a measure to determine the efficiency of a company in earning returns on the money invested by the equity shareholders. An investor will always be willing to invest in a company that commands a higher return on equity.
The formula for calculating ROE using DuPont Analysis is:
Return on Equity = Net Margin * Assets Turnover Ratio * Financial Leverage
To put the above formula in simple terms, consider the following formula.
Return on Equity = (Net Income/Sales) * (Sales/Assets) * (Assets/Shareholders’ Equity)
- Net Income/Sale is formula for calculating net margin, which determines operating efficiency.
- Sales/Assets is for calculating asset turnover ratio. This determines the efficiency in the utilization of assets in generating revenues.
- Assets/Shareholders’ Equity is financial leverage or equity multiplier. Or how best the funds have been used to generate the returns.
The above formula can be simply written as Net Income/Shareholders’ Equity, which is also the most commonly used formula of return on equity. But, the formula under the DuPont analysis is used to explain the effect of different factors in calculating ROE.
How to Calculate using Calculator?
Enter the following figures into the DuPont analysis calculator for quickly calculating return on equity.
The income of the company after paying off tax liability is its net income. This figure can be easily obtained from the statement of income and expenses.
Enter the amount of net sales that is, total sales after deducting sales returns (if any). This represents the revenue of the company from its operations.
Enter the amount of total assets of the company. This figure is simply available on the balance sheet of the company.
Shareholders’ equity includes equity capital and reserves and surplus available with the company. This is, per see, the kitty of shareholders.
Let us try to understand the concept well with the help of an example. The data of three companies (X, Y, and Z) are given as below:
|Particular||Company X||Company Y||Company Z|
The three factors under DuPont analysis are:
|Net Margin (a)||Net Income/Sales||0.20||0.99||0.16|
|Asset Turnover (b)||Sales/Total Assets||0.3||0.3||0.3|
|Financial Leverage (c)||Total Assets/Shareholders’ Equity||2||3.33||2.53|
The ROE under DuPont analysis is (a*b*c):
Company X = 0.2*0.3*2 = 0.12 or 12%
Company Y = 0.99*0.3*3.33 = 0.989 or 9.89%
And, Company Z = 0.16*0.3*2.53 = 0.12 or 12%
In the above example, the ROE of companies X and Z is 12%. While the ROE of company Y is 9.89% which means companies X and Z are better at generating returns for investors (shareholders) in comparison to company Y.
Du Pont’s analysis gives a different dimension to our understanding, though the ROE remains the same by this method or other shortcut methods. However, here if we observe the asset utilization efficiency is almost the same for all the three entities. However, there is wide variance with regard to the profit margin and financial leverage. Of course, in isolation, it does not say anything unless it is compared with a company belonging to the same industry segment. However, if all three belong to the same industry, then management can think about how to improve the margin and effective funds deployment. And that can lead to an improvement in the ROE.