DuPont Analysis

DuPont Analysis examines the return on equity (ROE) analyzing profit margin, total asset turnover, and financial leverage. It was created by the DuPont Corporation in the 1920s. Simply stated, ROE reveals how much after-tax profit a company earned in comparison to the total amount of shareholder equity found on the balance sheet. Return on equity is one of the most important indicators of a firm’s profitability and potential growth. Companies that boast a high return on equity with little or no debt relative to equity are able to grow without large capital expenditures, allowing the owners of the business to take freshly generated surplus cash and deploy it elsewhere.

Formula:

In a DuPont analysis, the formula for ROE is:

Return on Equity = Profit Margin x Total Asset Turnover x Financial Leverage

The formula breaks down further to:

ROE is not merely a ratio (as per the formula we started with) but a framework to understand the business and capital position of the company as a whole. Valuable insights can be derived from knowing which of the attributes drives the rise or deterioration of ROE over a period of time. It can also be used to compare companies with their peer sets to get a deeper understanding of the differences in the business models between the companies.

DuPont Analysis Components:

1. Profit Margin

Profit margin is the ratio of bottom-line profits compared to total revenue or total sales. For example, a company that sells a single product for Rp 120,000. After the costs associated with buying inventory, maintaining a location, paying employees, taxes, interest and other expenses, the company owner keeps Rp 20.000 in profit from each unit sold. That means the owner’s profit margin is 16,7%, which can be calculated as follows:

Profit Margin = Net Income / Revenue = Rp 20.000 / Rp 120.000 = 16,7%

2. Total Asset Turnover

The asset turnover ratio measures how efficiently a company uses its assets to generate revenue. For example, a company had Rp 10.000 of assets and it made Rp 100.000 of total revenue last year. The assets generated 10 times their value in total revenue, which is the same as the asset turnover ratio and can be calculated as follows:

Total Asset Turnover = Revenue / Average Assets = Rp 100.000 / Rp 10.000 = 10

The ratio can be helpful when comparing two companies that are very similar. Because average assets include components like inventory, changes in this ratio can signal that sales are slowing down or speeding up earlier than it would show up in other financial measures. If a company’s asset turnover rises, its ROE will improve.

3. Financial Leverage

Financial leverage is an indirect analysis of a company’s use of debt to finance its assets. For example, a company has Rp 100.000 of assets and Rp 25.000 of owner’s equity. The balance sheet equation will tell you that the company also has $750 in debt (assets – liabilities = equity). If the company borrows more to purchase assets, the ratio will continue to rise. The accounts used to calculate financial leverage are both on the balance sheet, so analysts will divide average assets by average equity rather than the balance at the end of the period, as follows:

Financial Leverage = Average Assets / Average Equity = Rp 100.000 / Rp 25.000 = 4

Most companies should use debt with equity to fund operations and growth. Not using any leverage could put the company at a disadvantage compared with its peers. However, using too much debt in order to increase the financial leverage ratio – and therefore increase ROE – can create disproportionate risks.

Example:

There are two automotive company, A and B. Both of these companies operate in the same model (LCGC) industry and have the same return on equity ratio of 45%. This model can be used to show strength and weaknesses of each company. Each company has the following ratios:

As we can see, both companies have the same ROE but company’s operation are completely different:

Summary:

The DuPont Analysis is important determines what is driving a company’s ROE; Profit margin shows the operating efficiency, asset turnover shows the asset use efficiency, and leverage factor shows how much leverage is being used. What many investors fail to realize, and where a DuPont Return on Equity analysis can help, is that two companies can have the same return on equity, yet one can be a much better business with much lower risks. This can have incredible consequences for your portfolio’s returns over long periods of time as the better business is able to generate more free cash flow or owner earnings.

Changing your mindset to view the world through the eyes of the DuPont model is a bit like giving yourself a superpower. Apply the insights you garner wisely and you can make a lot of money or, just as importantly, avoid disasters that could have otherwise harmed your portfolio. Happy Investing!

References:

• Phillips, Matt (9 December 2015). “The DuPont invention that changed how things work in the corporate world”. Quartz (publication). Retrieved 9 December 2015.
• https://www.thebalance.com/return-on-equity-roe-357601
• https://www.tradebrains.in/dupont-analysis/
• http://financialmanagementpro.com/dupont-analysis/

About Post Author

graceoliviads

A student of class EMBA59B in SBM ITB. Currently working as Procurement Staff in Honda Prospect Motor.

See author's posts

graceoliviads

A student of class EMBA59B in SBM ITB. Currently working as Procurement Staff in Honda Prospect Motor.