DuPont Analysis is an approach that breaks the Return on Equity (ROE) into a more detailed expression, thereby overcoming the shortcomings or loopholes of conventional ROE. It was developed by DuPont Corporation in the 1920s. DuPont analysis interprets the basic ROE ratio to provide a great insight into the company’s performance.
How to Calculate ROE?
It is the profit that a company derives for every dollar invested by the shareholders in the company. ROE or Return on Equity is given by:
|Return on Equity (ROE) = Net Income / Shareholder’s Equity|
Net Income = Net profit derived from the business
Shareholders’ Equity = Capital invested by shareholders of the company
ROE is a simple ratio and requires only 2 figures to calculate. Net Income and Shareholders Equity. The higher this ratio, the better are the returns that shareholders get for every dollar invested. So, ideally, from an investor’s point of view, Return on Equity should be as high as possible.
ROE focuses only on the returns of the equity shareholders. It only measures a percentage rate of return earned by the investors from the underlying company. Therefore, the scope of this ratio is relatively narrow. On the contrary, the ratio is converted into an expression by DuPont, which presents the returns earned by the investors and talks about three important parameters of a company’s performance. These three parameters are Profitability, Operating Efficiency / Asset Utilization, and Financial Leverage.
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Formula of DuPont Analysis
DuPont Analysis overcomes this drawback of ROE. It breaks ROE into 3 parts; thereby, one can analyze the reason for the increase/decrease in ROE.
|ROE = Net Income / Shareholder’s Equity|
Multiplying the equation by sales
|ROE = (Net Sales / Shareholder’s Equity) * (Income / Sales)|
Again multiplying the above equation by assets/assets
|ROE = (Net Income / Sales) * (Sales / Assets) * (Assets / Shareholder’s Equity)|
The above equation for ROE is broken down into 3 components:
- Net Income / Sales = Operating Efficiency (as measured by profit margin).
- Sales / Assets = Asset Utilization (as measured by total asset turnover).
- Assets / Shareholders’ Equity = Financial leverage (as measured by the equity multiplier).
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Use of DuPont Analysis
Using the modified equation of Return on Equity, one can make a more informed decision and understand the company’s position better. If the Return on Equity increases due to an increase in operating efficiency or improved asset utilization, it is a good sign for investors. It would imply that either company is making higher margins on its sales, the company is making better use of its assets, or both.
On the other hand, if the Return on Equity increases on account of financial leverage, it would imply that the profit is due to the company’s financial strategy rather than good operations. Too higher a debt ratio also makes a company a riskier proposal for investment.
In essence, a manager should try increasing the ROE by either higher operating efficiency or better asset utilization. There is no reservation for using the third parameter, i.e., financial leverage, but it will increase the risk of bankruptcy if the lenders ask for a large sum of money.
Example Explaining DuPont Analysis
Consider a hypothetical scenario of companies X and Y with the below numbers.
|1. Operating Profit Margin Ratio||0.20||0.12|
|2. Asset Turnover Ratio||0.30||0.30|
|3. Financial Leverage or Equity Multiplier||2.00||3.33|
ROE for both the companies is the same viz. 12%. But company X has a better Operating margin than company Y. Hence, X can be considered a safer option to invest in than Y.
Read more about other Methods of Financial Analysis.
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Thanks for your help sir
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