DuPont analysis is a modification of Return on Equity (ROE) which uses a gross asset value rather
than net asset value in its calculation. It is named after DuPont Corporation who
developed a detailed model for assessing a company’s profitability in the 1920’s,
later named “DuPont Analysis.” Return on Equity, or ROE, is commonly
used as an accounting ratio for assessing a company’s overall profitability. Ratios which
calculate ROE measures a business’s ability to generate revenue relative to its expenses.
Return on Equity is traditionally calculated by dividing net income by common equity.
The basic DuPont Analysis model breaks down the original equation for ROE into three components:
operating efficiency, asset efficiency, and leverage.
There are three categories of ROE in the DuPont Analysis model. They are operating efficiency,
asset efficiency, and financial leverage. • Operating efficiency is measured with Net Profit
Margin. This metric determines how many dollars in net sales are generated per dollar in expenses..
• Asset efficiency is measured by the Total Asset Turnover.
This metric determines how many dollars of total revenue a company generates per dollar in assets.
• Financial leverage is determined by the Equity Multiplier, or the ratio that measures
the value of a company’s assets relative to the value of stockholder's equity.
The equation for the basic DuPont model is: ROE = Net Profit Margin x Total Asset Turnover
x Equity Multiplier We can also represent
these components as ratios: Notice that the equation is still the
same as Return on Equity since sales and total assets effectively cancel each other out.
Net Profit Margin and Total Asset Turnover assess the operations of the
business. Larger values for these metrics indicate a more productive business.
Financial leverage evaluates how effectively the company in question is using debt to finance its
activities. If a company has $1 M of assets and $250,000 of equity, its equity multiplier is 4,
because its assets are 4 times greater than its equity. The balance sheet will
show that the company has $750,000 in debt since assets - equity = liabilities.
If the value of assets depreciates over time, the equity multiplier
will decrease, all else being equal. By borrowing more to purchase new assets,
management can increase the financial leverage ratio, thereby increasing ROE. This is why
basic ROE analysis can be misleading. The DuPont model uses gross asset value,
which ignores depreciation, instead of net asset value.
Using gross asset value no longer incentivizes managers to borrow more and invest in new assets.
This encourages managers to get the most out of the useful life of the asset.
It’s important to note that borrowing more money increases leverage and creates a higher
risk of default, but borrowing more isn’t inherently bad. If a company can borrow
money at low interest rates and put capital to good use, it can grow the company faster
and generate higher returns for investors. By breaking out the traditional Return on
Equity equation using DuPont analysis into net profit margin, total asset turnover,
and equity multiplier, investors can analyze the reason for an increase or decrease in ROE. If ROE
increases due to higher leverage rather than a greater net profit margin or asset turnover,
additional leverage may not be adding any real value to the firm.
This is why DuPont Analysis offers more insight than basic ROE analysis.
Let’s hear from you. Do you think companies should use equity,
debt, or a mix of both to finance business activities? Leave a comment below.