DuPont analysis is a model widely used in financial ratio analysis to designate the ability of a company to increase its return on equity ratio (ROE). The model breaks down ROE ratio into three components: profit margin, asset turnover, and financial leverage.
The DuPont model is expressed as follows:
ROE = Profit margin × Asset Turnover × Financial Leverage
Profit margin, also known as net profit margin, is usually calculated for common shareholders; thus, net income less preferred dividends (if available) should be used.
Average total assets are the sum of total assets at the beginning and at the end of the period divided by 2.
Value of total assets and shareholders’ equity can be found in the balance sheet, net sales and net income can be found in the income statement, and preferred dividends can be found in the notes to the financial statements.
DuPont model interpretation
DuPont analysis breaks down return on equity into three major components to determine the impact of each of them.
- Profit margin. This ratio reflects a company’s strength in generating profit from each dollar of sales.
- Asset turnover. This ratio measures how efficiently a company uses its assets to generate sales.
- Financial leverage or equity multiplier. This ratio shows the extent to which a company uses debt financing. The greater the value of a ratio, the greater the risk and uncertainly of expected ROE.
The goal of DuPont analysis isn’t to calculate ROE but to identify factors affecting it. If investors are not satisfied with the current ROE ratio, management can analyze what problems caused its current value and attempt to solve them.
The balance sheet of XYZ company is as follows:
Balance sheet, US$ in thousands
The reported statement of income for the 20X8 financial year is as follows:
XYZ company has declared total preferred dividends of $250,000.
To find net income attributable to common shareholders, we needed to subtract the total amount of preferred dividends of $250,000.
The average total assets are $54,420,000 ([$52,970,000 + $55,870,000] ÷ 2); thus, asset turnover ratio is as follows:
The total common shareholders’ equity at the end of the current year is $31,740,000 ($33,740,000 – $2,000,000) and $34,060,000 ($36,060,000 – $2,000,000) at the beginning of the year. Thus, the average common shareholders’ equity is $32,900,000 ([$31,740,000 + $34,060,000] ÷ 2).
In terms of the DuPont model, the ROE of XYZ company is 15.47%.
ROE = 11.16% × 0.84 × 1.65 = 15.47%
Let’s assume another company of the same size operating in the same industry having a profit margin ratio of 11.23%, an asset turnover ratio of 1.19, and financial leverage of 1.16. It has the same ROE of 15.47%.
ROE = 11.23% × 1.19 × 1.16 = 15.47%
Although both companies have about the same profit margin, DuPont analysis shows they have different strengths and weaknesses in assets turnover and financial leverage. XYZ company can increase its ROE by improving assets utilization, and the other company can increase its financial leverage ratio.
The DuPont model can be more complicated than the 3-factor model mentioned above. For example, more detailed analysis can be done using the 5-factor model.
where EBIT is earnings before interest and tax, and EBT is earnings before tax.
For deeper insight, the 5-factor DuPont model additionally breaks down profit margin into three components to determine the impact of interest and the tax burden.
An example of deeper decomposition of ROE is shown in the DuPont chart below.
Advantages and disadvantages of DuPont analysis
DuPont analysis is an excellent technique to determine the strengths and weaknesses of a company. Each weak financial ratio used in the model can be decomposed to get deeper insight into the source of weakness. When sources of weakness are identified, management can take some actions (e.g., improve expense control, asset management, or marketing) to improve the return on equity ratio.
The main drawback of DuPont analysis is that it uses accounting data disclosed in financial statements, which can be manipulated by management to hide some weaknesses. Thus, to get correct results, accurate accounting data must be inputted.
Another disadvantage is inherent to all financial ratio analysis systems. It works best to compare companies of the same size working in the same industry.