What is DuPont Analysis?
DuPont Analysis is an extended examination of Return on Equity (ROE) of a company which analyses Net Profit Margin, Asset Turnover, and Financial Leverage. This analysis was developed by the DuPont Corporation in the year 1920.
In simple words, it breaks down the ROE to analyze how corporate can increase the return for their shareholders.
Return on Equity= Net Profit Margin x Asset Turnover Ratio x Financial Leverage
= (Net Income / Sales) x (Sales / Total Assets) x (Total Assets / Total Equity)
Individuals at all levels who would want to learn fundamental analysis and analysis beyond valuations can register for Equity Research Analysis course certified by NSE Academy.
The company can increase its Return on Equity if it-
1. Generates a high Net Profit Margin.
2. Effectively uses its assets so as to generate more sales
3. Has a high Financial Leverage
What are the Components of DuPont Analysis
DuPont analysis has 3 components to consider;
1.Profit Margin– This is a very basic profitability ratio. This is calculated by dividing the net profit by total revenues. This resembles the profit generated after deducting all the expenses. The primary factor remains to maintain healthy profit margins and derive ways to keep growing it by reducing expenses, increasing prices etc, which impacts ROE.
For example; Company X has Annual net profits of Rs 1000 and Annual turnover of Rs 10000. Therefore the net profit margin is calculated as
Net Profit Margin= Net profit/ Total revenue= 1000/10000= 10%
2. Total Asset Turnover– This ratio depicts the efficiency of the company in using its assets. This is calculated by dividing revenues by average assets. This ratio differs across industries but is useful in comparing firms in the same industry. If the company’s asset turnover increases, this positively impacts the ROE of the company.
For example; Company X has revenues of Rs 10000 and average assets of Rs 200. Hence the asset turnover is as follows
Asset Turnover= Revenues/Average Assets = 1000/200 = 5
3. Financial Leverage- This refers to the debt usage to finance the assets. The companies should strike a balance in the usage of debt. The debt should be used to finance the operations and growth of the company. However usage of excess leverage to push up the ROE can turn out to be detrimental for the health of the company.
For example; Company X has average assets of Rs 1000 and equity of Rs 400. Hence the leverage of the company is as
Financial Leverage = Average Assets/ Average Equity= 1000/400 = 2.5
DuPont Analysis Interpretation
DuPont Analysis gives a broader view of the Return on Equity of the company. It highlights the company’s strengths and pinpoints the area where there is a scope for improvement. Say if the shareholders are dissatisfied with lower ROE, the company with the help of DuPont Analysis formula can assess whether the lower ROE is due to low-profit margin, low asset turnover or poor leverage.
Once the management of the company has found the weak area, it may take steps to correct it. The lower ROE may not always be a concern for the company as it may also happen due to normal business operations. For instance, the ROE may come down due to accelerated depreciation in the initial years.
The DuPont equation can be further decomposed to have an even deeper insight where the net profit margin is broken down into EBIT Margin, Tax Burden, and Interest Burden.
Return on Equity = EBIT Margin x Interest Burden x Tax Burden x Asset Turnover Ratio x Financial Leverage
ROE = (EBIT / Sales) x (EBT / EBIT) x (Net Income / EBT) x (Sales / Total Assets) x (Total Assets / Total Equity)
You can watch the video below to get a more clear idea of DuPont Analysis :
How is DuPont ROE calculated?
There are a few changes in the calculation part when calculating ROE under the two approaches. Let us understand the difference in calculation. Basically in the DuPont analysis, the three components discussed above are taken into account for calculation.
The simple ROE helps in the understanding the return generated by the company on its equity. But the reasons behind that (whether good or bad) is understood by the DuPont analysis.
In simple ROE, we calculate
ROE = Net Income/ Total equity
But while calculating DuPont ROE, we include a few more factors andcalculate it as follows,
DuPont ROE = (Net Income/ Sales) * (Net Sales/Total Assets) * (TotalAssets/Total Equity)
Profit Margin * Total Asset Turnover * Equity Multiplier
This helps in understanding which component is impacting ROE more.
Although DuPont has many advantages as stated above, but everything hasits own disadvantages also.
The DuPont analysis uses accounting data from the financial statement in its analysis which can be manipulated by the management to hide discrepancies.
It is only useful for comparison between the companies under the same industry.
Can DuPont analysis be applied on a zero debt company?
After learning a new concept of DuPont analysis, we must be wondering
that whether this analysis is also done on a debt free company? Whether this
analysis will have the same usefulness for a debt free company or not?
DuPont Analysis is equally useful when analysing a debt free company. The above formula remains the same, with just one exception- the financial leverage component is taken as 1 and the rest remains the same. Therefore the DuPont analysis can be performed on all kinds of companies.
3 Step and 5 steps DuPont Analysis:
The 3 step DuPont analysis have been discussed above, which is
ROE= (Net Income/ Sales) * (Net Sales/Total Assets) * (Total Assets/Total
Profit Margin * Total
Asset Turnover * Equity Multiplier
However, the 5 step DuPont analysis has two additional components;
ROE = (Net Income/ Pretax Income) * (Net Sales/Total Assets) * (Total
Assets/Total Equity) * (Pretax Income/ EBIT)* (EBIT/Sales)
= Tax Burden * Asset Turnover * Equity Multiplier * Interest Burden * Operating Margin.
DuPont Analysis Example:
Let’s analyze the Return on Equity of Companies- A and B. Both the companies are into the electronics industry and have the same ROE of 45%. The ratios of the two companies are as follows-
Ratio Company A Company B
Profit Margin 30% 15%
Asset Turnover 0.5 6
Financial Leverage 3 0.5
Even though both companies have the same ROE, however, the operations of the companies are totally different.
Company A is able to generate higher sales while maintaining a lower cost of goods which can be seen from its high-profit margin.
On the other hand, company B is selling its products at a lower margin but having very high Asset Turnover Ratio indicating that the company is making a large number of sales. Moreover, company B seems less risky since its Financial Leverage is very low.
Thus DuPont Analysis helps compare similar companies with similar ratios. It will help investors to measure the risk associated with the business model of each company.
Click here to calculate with the help of DuPont Analysis calculator.
You can also see a snapshot of DuPont Analysis Calculator below:
Dupont Analysis Calculator:
DuPont Analysis is very important for an investor as it answers the question what is actually causing the ROE to be what it is. If there is an increase in the Net Profit Margin without a change in the Financial Leverage, it shows that the company is able to increase its profitability.
But if the company is able to increase it’s ROE only due to increase in Financial Leverage, it’s risky since the company is able to increase its assets by taking debt.
Thus we need to check whether the increase in company’s ROE is due to increase in Net Profit Margin or Asset Turnover Ratio (which is a good sign) or only due to Leverage (which is an alarming signal).