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:
- It earns a high net profit margin;
- It uses its assets effectively to generate more sales; and/or
- It has a high financial leverage
According to DuPont analysis:
|Return on Equity = Net Profit Margin × Asset Turnover × Financial Leverage|
|Return on Equity =||Net Income||×||Sales||×||Total Assets|
|Sales||Total Assets||Total Equity|
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|
|Sales||EBIT||EBT||Total Assets||Total 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 A||Company B|
|Net Profit Margin||10%||10%|
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