DuPont Analysis

DuPont analysis is an extended analysis of a company's return on equity. It concludes that a company can earn a high return on equity if:

  1. It earns a high net profit margin;
  2. It uses its assets effectively to generate more sales; and/or
  3. It has a high financial leverage

Formula

According to DuPont analysis:

Return on Equity = Net Profit Margin × Asset Turnover × Financial Leverage
Return on Equity = Net Income × Sales × Total Assets
SalesTotal AssetsTotal Equity

Analysis

DuPont equation provides a broader picture of the return the company is earning on its equity. It tells where a company's strength lies and where there is a room for improvement.

DuPont equation could be further extended by breaking up net profit margin into EBIT margin, tax burden and interest burden. This five-factor analysis provides an even deeper insight.

ROE = EBIT Margin × Interest Burden × Tax Burden × Asset Turnover × Financial Leverage
Return on Equity = EBIT × EBT × Net Income × Sales × Total Assets
SalesEBITEBTTotal AssetsTotal Equity

Example: Three-factor Analysis

Company A and B operate in the same market and are of the same size. Both earn a return of 15% on equity. The following table shows their respective net profit margin, asset turnover and financial leverage.

Company ACompany B
Net Profit Margin10%10%
Asset Turnover11.5
Financial Leverage1.51

Although both the companies have a return on equity of 15% their underlying strengths and weaknesses are quite opposite. Company B is better than company A in using its assets to generate revenues but it is unable to capitalize this advantage into higher return on equity due to its lower financial leverage. Company A can improve by using its total assets more effectively in generating sales and company B can improve by raising some debt.

Written by Obaidullah Jan