Written By Team CFI
The DuPont Analysis tool assesses the ability of a company to improve its Return on Equity (ROE), which measures the profitability of a business with respect to equity. The analysis came up as a blessing for investors and financial analysts as it helps them decompose the factors leading to profits and thereby enhance the same for better performance in the future.
- The Components
- The Models
- o Three Step Model
- o Five Step Model
- Example With Calculation
DuPont Analysis helps a business be aware of the contribution of each part of the ROE in determining its growth and profitability. Therefore, it is considered the fundamental tool for a performance assessment that analyses different parameters and factors affecting investor returns.
For example, when the net profit margin of a company is more, it is difficult to say whether it is the increased revenue that has led to the enhanced profits or reduced expenses or costs. DuPont Analysis is the technique that can help a business identify the contribution of revenue and expenses individually to assess their performance separately. As a result, companies get an opportunity to improve the performance of all individual factors accordingly.
The Return on Equity on which the entire DuPont Analysis is based is divided into the following components:
Net Profit Margin is the ratio of net sales to revenue. It is the measure of the profitability of a business.
The profit margin of a business is affected positively by either the decrease in the owner cost or the increase in the prices. This is why the volatility of stocks of a particular company fluctuates with the change in its costs, prices, or other guidelines.
Asset turnover measures the efficiency with which businesses utilize assets to generate revenue.
This ratio helps assess the performance of two companies having similar characteristics.
Financial leverage is a liquidity ratio that indicates the total capital being funded by shareholders and by debt. It is expressed as:
Equity = Assets – Liabilities
The Dupont analysis models are available in three forms. All three forms, however, are derived from the very basic ROE expression:
The three-step model can be derived from the above equation by multiplying Asset Turnover and Financial Leverage Ratios.
Thus, the Three-Step DuPont Analysis indicates that when the ROE of a company is high, it is either because of the increase in the Net Profit Margin Asset Turnover or increased debt capital.
The Five-Step model is derived from the two-step model formula of ROE, i.e.:
Example with Calculation
Let’s say DuPont Analysis is to be used to check which company between A and B is performing better. Which one is a better performer?
To do so, here are the details to know, which have already been shared:
|Company A||Company B|
|Net profit margin = 35||Net profit margin = 28|
|Asset Turnover Ratio = 0.5||Asset Turnover Ratio = 0.5|
|Financial leverage ratio = 0.8||Financial leverage ratio = 1|
Example Answer: Though the ROE of both the companies is the same, the DuPont analysis still helps to figure out the better performer, which is company A in this context. Why?
Answer Explanation: Net Profit Margin of Company A is better than B and requires LOWER leverage than Company B to complete. Hence it can be concluded that with even lower leverage, Company A performs better
- What is DuPont Analysis?
DuPont Analysis, created by Donaldson Brown, a Treasury Department ace at DuPont Corporation, in 1920, is the technique using which the performance of the parameters leading to profits or losses are individually analyzed and assessed.
- Why is DuPont analysis important?
DuPont Analysis helps a business know the contribution of each part of the ROE in determining its growth and profitability. Therefore, it is considered the fundamental tool for a performance assessment that analyses different parameters and factors affecting investor returns.
- How does it work?
When the net profit margin of a company is more, it is difficult to say whether it is the increased revenue that has led to the enhanced profits or it’s the reduced expenses or costs. DuPont Analysis is the technique that can help a business identify the contribution of revenue and expenses individually to assess their performance separately.