DuPont Analysis
It is a framework to analyze the performance of a company
The DuPont analysis, also known as the DuPont identity, is a fundamental framework for performance assessment. The analysis got its name from the DuPont Corporation.
A large American company founded in 1802 as a gunpowder mill by French-American chemist and industrial expert Eluthere Irenee du Pont.
It can be used to analyze the various factors influencing the returns that investors receive from an organization.
We can also refer to it as the Return on Equity: the ratio between the profits of a company and the capital used to achieve these profits.
This business-economic analysis tool can help accountants and financial managers analyze a company's profitability without drawing misleading conclusions.
This analysis method breaks down and clarifies the different components of the Return on Equity (ROE) formula, which can help companies find ways to improve their return on equity.
Moreover, organizations employ this method to improve their financial performance and increase the return they can offer to investors and shareholders.
Components
ROE is broken down into various parts to determine and gain a clear picture of how its various components impact its value and the ways to influence them to improve its overall value eventually.
Net Profit Margin
This refers to the ratio of total profits compared to total sales generated by a firm. This ratio is a core measure of a firm's profitability or gains. Let us look at a sole trading business to put this into a practical example. Assuming that the sole trader sells a unit of a bag for $15.
Now, since the sole trader is not a producer and doesn't own the raw materials he's currently using, he must incur a cost of production.
Therefore, if the production cost of a unit of bottled juice is $14 (raw materials, taxes, labor, etc.), the profit the sole trader would realize per fruit juice sold would stand at $1.
In simple words, the business owner's profit margin is equivalent to 20% of the cost of a unit of his product.
This can be computed as :
Net Profit Margin = net income/ revenue= $1/ $15 = 6.66%.
The example illustrated above can help the sole trader to take the appropriate actions by either increasing the cost of goods and services or reducing the cost of production. Any actions taken in this case would directly impact the returns on equity ( ROE).
Asset Turnover Ratio
This looks at how a company uses its assets efficiently to generate revenue or income. In simple terms, it indicates the number of sales generated for each dollar's worth of assets. Here, the higher the ratio, the better it is for a business.
Let's take an example of a coffee business owned by Tom. In this instance, the total value of Tom's assets is worth $1,000 and determines that $600 of his assets are for revenue generation.
If Tom can generate a revenue of $3,000 at the end of the year by using that amount, we can conclude that he generated ten times the value in total revenue. This equals an asset turnover which can be computed as follows:
Asset Revenue / Average Assets = $3000/ $600 = 5 times.
Typically, the ROE of any business is anticipated to increase if its asset turnover ratio goes up.
This ratio measures the magnitude to which a company depends on debt financing. A high financial leverage ratio implies that a business is incurring a high level of debt.
For example, if Tom has a total asset value of $3,000 and $1000 as equity, we can say that the latter will incur a total debt of $2400 ( Debt= Total Assets - Equity). If Tom plans to borrow more money to fund any investments, the leverage ratio shall go up.
The financial leverage ratio is widely used by firms when undertaking projects and investments and funding their operations. A firm that uses the latter is better positioned to compete with rival businesses as they can adopt an effective expansion plan when investing in an asset.
The above example can be computed as:
Financial Leverage= Average Assets / Average Equity= $3000/ $1000= 3
Following the calculation, Organization X's return of equity is:
ROE = 6.66% * 5 * 3 = 99.99%
Analysis Interpretation
It gives a broader perspective of the return on equity of the company. It highlights the company's strengths and points out the segments where there is a scope for improvement.
For instance, if shareholders are dissatisfied with a low ROE, the company can use Dupont analysis to assess the ratio components responsible for such a result.
From the example above, the business has an ROE of 99.99%, which means it generates $0.99 for each $1 of its equity capital. For prospective investors, this is an essential piece of information as it illustrates the efficiency of a company at using its money to increase its net income.
Business-economic analysts typically rely on this method to analyze an organization and conclude ideas about its strengths and weaknesses and how it can improve efficiency. For example, analysts believe companies with an ROE of less than 12- 14 % signal a high investment risk.
Investing in organizations with an ROE of 20% and above is considered an acceptable and safe investment. For instance, the ROE of Apple Inc increased from 17.88% in 2005 to reach 36.07% in 2017, which is a positive signal to prospective investors.
The DuPont Formula: 3 Step Return on Equity
The formula is:
(Net Income/ Sales)* (Sales/ Assets) * (Assets/ Equity)
By combining all three ratios, the DuPont analysis provides a more detailed insight into the organization's health compared to the simple ROE calculation (annual earnings/shareholder's equity).
For instance, if a company's return on equity increases due to an improvement in its net profit margin (net income/sales) or its asset turnover (sales/assets), this is a positive indicator.
On the other hand, if the assets to equity result are the reason for the increase, the company might be over-leveraged (high level of debt), which puts the company in a risky situation.
The equation can further be broken down to explain a company's ROE more thoroughly. But, first, the net profit margin is broken down into EBIT margin, tax burden, and interest burden.
Return on Equity = EBIT Margin * Interest Burden * Tax Burden * Asset Turnover ratio * Financial leverage
ROE = ( EBIT/ Sales) * ( EBT/ EBIT) * (Net Income/ EBT) * ( Sales/ Total assets) * (Total assets/ Total Equity)
Pros and Cons
The pros & cons are:
Advantages
It is an effective financial tool if you want to understand a company's strengths and weaknesses. Each financial ratio can be observed separately, and any weakness or low ratio can be analyzed further better o better understand the underlying reason for that weakness.
During the calculation, any poor ratio can be diagnosed, enabling the company's management to take measures ranging from tighter cost control, better marketing strategies, and setting up a more efficient asset management department.
Disadvantages
It uses data from a company's income statement and balance sheet. A major setback of the above practices could be that the financial data used to get the ROE might have been manipulated to hide shortcomings.
Moreover, the value obtained alone is not an effective indicator of a company's financial performance. For example, DuPont analysis doesn't consider the ratio's relative value compared to the industry norms. It is hence important to evaluate how a company has performed against its business peers or own past performances.
Lastly, the analysis doesn't consider seasonal factors. For example, certain companies always carry high inventory levels during certain times of the year, which might make evaluating a company difficult.
FAQs
It is a model used to evaluate a company's fundamental performance.
This analysis consists of three variables: Net Profit Margin, Asset Turnover, and Equity Multiplier. We then multiply these three components to obtain the final result, which is expressed as a percentage.
The latter is named after the DuPont Corporation, which developed the model in the early 1920s.
The 3-step analysis is the most widely used among the two, including Net Profit Margin, Asset Turnover, and Equity Multiplier. On the other hand, the 5-step analysis includes two more ratios, which are the Return on Assets (ROA) and Return on Invested Capital (ROIC)
We can also say that the 5-step analysis provides a better overview of a company's financial performance.
The latter allows companies to gain a more comprehensive understanding of their financial performance and eventually take the appropriate steps to boost their ROE.
Moreover, it can be used to compare the performance of two homogeneous companies.
Prospective investors can also use this analysis to gauge a company's strengths and weaknesses.
The latter helps management identify the areas of problems that influence profit. It enables management to visualize the various forces affecting profits and how they can be improved either by putting capital into effective use.
It will result in a higher turnover ratio or better sales effort, which will result in a higher profit ratio.
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