The DuPont Ratio is a financial ratio that is used to assess the ability of a company to increase its return on equity based on the ROE ratio. This is normally presented as a product of the profit margin, total asset turnover and the financial leverage (this is measured by the equity multiplier). In other contexts, it is viewed as a model that attempts to break down the return on equity of a company to explain how it increases its return for investors. Based on the performance of these components, the model can ascertain whether a company can increase its ROE by maintaining high profit margins, increasing its asset turnover or leveraging assets in a more effective manner.
Formula
The DuPont ratio equates Return on Equity to profit margin, asset turnover and financial leverage. The formula is presented below:
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Return on Equity = Profit Margin Total Asset Turnover Financial Leverage
Since each of the components is determined by dividing other factors, a more detailed formula for the DuPont ratio can also be represented as
Return on Equity =
All the financial components in the formula can be found in a company’s financial statements. The sales and net income appear in the income statement whereas total equity and total assets appear in the balance sheet.
DuPont Ratio Components
This financial ratio breaks ROE into its constituent components so that it can determine the factor that is most responsible for the changes in ROE ( Goel, 2016 ).
Profit Margin. This is normally expressed as a percentage of the net income and net sales. It can be referred to as the revenue that is obtained after deducting all operating expenses, interest and preferred stock dividends, taxes and liabilities from a company’s total revenue.
Asset Turnover Ratio. This is an efficiency ratio that is used to determine the effectiveness with which a company uses its assets to generate revenue. The higher the figure obtained, the better the performance of the company.
Equity Multiplier. This ratio provides a measure of the financial leverage. It basically indicates whether a company finances the purchase of assets primarily through debt or equity by comparing total assets to total stakeholder’s equity ( Goel, 2016 ). A high equity multiplier value indicates that a company is more leveraged, meaning that it has more debt in relation to its total assets.
The DuPont analysis examines the changes that occur in the figures of the components over a given period of time and relates them to the changes in ROE. By using this model, analysts are able to determine whether it is the profit margin, asset use efficiency or financial leverage that is most responsible for ROE variations.
DuPont Analysis
Goel (2016) notes that the DuPont ratio is an important financial tool because it helps in determining the factors that drive a company’s ROE. The profit margin represents the operating efficiency, asset turnover expresses asset use efficiency and the leverage factor shows the amount of leverage that is being used. The method goes beyond the basic understanding of the profit margin to illustrate the proficiency with which a company’s assets generate cash or sales. It also explains how efficiently a business enterprise uses its debt to produce incremental returns. Analysts can therefore use the components of the DuPont model to examine a company and determine its operating efficiency by pinpointing its strong and weak points. In other words, the ratio shows which areas need immediate attention from the inventory management, margins, debt structure among others.
The DuPont model makes use of both the income statements and the balance sheet during internal examination. This means that major asset acquisitions, purchases and other significant changes can interfere with the ROE calculation. Consequently, many financial analysts opt to use shareholder’s equity and average assets to mitigate the distortion even though this approach is based on the assumption that balance sheet changes occur steadily over the course of a particular year, which may not be accurate to presume.
The model was developed for the purpose of analyzing ROE and the impact of different business performance measures on the ratio ( Goel, 2016 ). This means that investors neither look for small nor large output figures from this model. They instead seek to determine the factors that cause a fluctuation of the current ROE. For instance, we may take an example of investors who are unsatisfied with a low ROE. In this case, the management can opt to use this analysis to identify the area with the problem whether it is the asset turnover, poor financial leveraging or low profit margins.
Once the problem is found, the management can either correct or address it with the shareholders by coming up with an effective solution. It is imperative to note that some normal operations within an organization can lower the ROE and as such investors should not be alarmed. This can be the case where the ROE is artificially lowered by an accelerated depreciation at the beginning of a business quarter. The DuPont analysis helps to identify these kinds of fluctuations and provides a company with the appropriate data for making sound business decisions.
References
Goel, S. (2016). Financial ratios . Business New York: Expert Press.
