The DuPont analysis is a method of using financial ratios to assess the financial performance of a business.
Original Dupont Analysis
The original DuPont analysis analyses return on assets (ROA) into component parts.
ROA = Net income / Assets ROA = (Net income / Revenue) x (Revenue / Assets) ROA = Profit margin x Asset turnover
As can be seen 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 model 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
Extended Dupont Analysis
As can be seen 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.
Consequently using the DuPont model an investor can see which elements of the business contribute to their total return on equity by looking at:
- Firstly how efficiently sales are being used to generate profits (net profit margin)
- Secondly how well assets are being used to generate revenue (Asset turnover)
- Finally 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 | |
|---|---|---|
| Net income | 30,000 | 63,000 |
| Revenue | 350,000 | 600,000 |
| Assets | 300,000 | 630,000 |
| Equity | 100,000 | 210,000 |
Accordingly 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 | 8.6% | 10.5% |
| Asset Turnover | 3.50 | 0.95 |
| Equity multiplier | 1.0 | 3.0 |
| Return on equity (ROE) | 30% | 30% |
Both businesses have the same return on equity for investors, however, the DuPont equation 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 model 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
As can be seen 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. Additionally 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.
Analysis Summary
Additionally 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.
About the Author
Chartered accountant Michael Brown is the founder and CEO of Double Entry Bookkeeping. He has worked as an accountant and consultant for more than 25 years and has built financial models for all types of industries. He has been the CFO or controller of both small and medium sized companies and has run small businesses of his own. He has been a manager and an auditor with Deloitte, a big 4 accountancy firm, and holds a degree from Loughborough University.