The DuPont analysis is a method of using financial ratios to assess the financial performance of a business.
The original DuPont analysis was used to analyse return on assets (ROA) into component parts.
ROA = Net income / Assets ROA = (Net income / Revenue) x (Revenue / Assets) ROA = Profit margin x Asset turnover
This original DuPont analysis formula showed that the return on assets is a function of the profitability of the business represented by the profit margin ratio, and the operational efficiency of the business represented by the asset turnover ratio.
This formula however does not show the effect of the financial leverage (the amount of debt) within the business, and so the DuPont analysis was extended to analyse the return on equity (ROE)
ROE = Net income / Equity ROE = (Net income / Revenue) x (Revenue / Assets) x (Assets / Equity) ROE = Net profit margin x Asset turnover x Equity multiplier or alternatively ROE = ROA x Equity multiplier
This extended DuPont analysis shows that the return on equity to an investor is a function of the profitability (indicated by the net profit margin ratio), the operational efficiency represented by the asset turnover ratio, and the financial leverage represented by the ratio of assets to equity, and known as the equity multiplier.
Using the DuPont analysis, an investor can see which elements of the business contribute to their total return on equity by looking at:
- How efficiently sales are being used to generate profits (net profit margin)
- How well assets are being used to generate revenue (Asset turnover)
- How much the business is using financial leverage (Equity multiplier)
DuPont Analysis Example
As an example of DuPont analysis, suppose the accounts of two businesses show the following financial information:
|Business A||Business B|
Using the DuPont analysis we can calculate the return on equity for both of these businesses as follows:
|Business A||Business B|
|Net profit margin||9%||11%|
|Return on equity (ROE)||30%||30%|
Both businesses have the same return on equity for investors, however, the DuPont analysis shows that despite having similar profitability, business A has no leverage and gets its return from efficient use of its assets shown by the higher asset turnover ratio, whereas business B generates the investor return using financial leverage shown by the higher equity multiplier.
A further extension of the first term of the DuPont analysis produces the five ratio formula
ROE = (Net income / Revenue) x (Revenue / Assets) x (Assets / Equity) ROE = (Operating income / Revenue) x (Revenue / Assets) x (Income before tax / Operating income) x (Assets / Equity) x (Net income / Income before tax) ROE = Operating margin x Asset turnover x Financial cost ratio x Equity multiplier x Tax effect ratio
The first two terms, operating margin and asset turnover represent the operational aspects of the business, how much profit can be obtained from revenue, how well assets are managed. The next two terms, financial cost ratio, and equity multiplier show how the return on equity is effected by the capital structure and finance costs of the business. And finally the tax effect ratio shows the impact of taxation on the return on equity.
DuPont Analysis Summary
The formulas developed on this page are summarized for easy reference in the diagram below.
The DuPont analysis summary is available for download in PDF format by following the link below.