DuPont analysis is a technique which is used to analyze a company able to increase its return on equity (ROE) based on Profit margin, total asset turnover and financial leverage the DuPont analysis concludes that a company can raise its ROE by maintaining a high-profit margin, increasing asset turnover to increase more sales or leveraging assets more efficiently (equity multiplier).
The DuPont model compare ROE to profit margin, asset turnover and financial leverage (equity multiplier). The simple formula by equating ROE are as follows:
Return on equity (ROE) = Profit margin * Total assets turnover * financial leverage
The profit margin can be obtained by net income divide by sales, total assets turnover can be obtained by net sales divided by average total assets and financial leverage can be obtained by total assets divided by total equity.
Each figure can be obtained easily from financial statements. Net Income and sales appear on the income statement where total assets and total equity are found in the balance sheet.
DuPont model helps to analyze ROE and evaluates the performance measure of the business and their effects based on ROE. Investors have a concern about the current ROE not about the ROE result whether they are big or small in numbers. Therefore, if the investors are not satisfied with a low ROE then management can relate ROE with a different component such as profit margin, total asset turnover, and financial leverage to find out the problems area whether there is lower profit margin, asset turnover or it is below the financial leverage.
After verifying the problem area, management can solve the problem by addressing the issues with shareholders. The scenario can be different like some normal operation lower ROE in some cases and investors don’t decide based on the small output. The reason can be accelerated depreciation artificially lowers ROE in the beginning periods. The result can be evaluated by DuPont analysis and helps the management to make decisions based on the ROE and three other components.
PP and AA are two retailers company which sell the same products and have the same return on equity ratio of 45 percent. The DuPont model can be used to show the strengths and weaknesses of each company. The company has each ratio which are the following:
Ratio PP AA
Profit margin 30% 15%
Total Asset Turnover 0.50 6.0
Financial leverage 3.0 .50
From above example, both PP and AA companies have the same overall ROE, but the companies operations are majorly different.
0.30*0.5 *3 =45%
PP generates sales while maintaining a lower cost of goods as result show higher profit margin. PP has suffers turning over large amounts of sales.
AA business on the other way , is selling products at a smaller margin , but AA business is turning over a lot of products. From above we can analyze that AA business has low profit margin and huge asset turnover .
The DuPont model helps investors to compare related to similar ratios. Investors can use judgemental analysis based on applying perceived risks with each company’s business model.