DuPont analysis is also known as DuPont identity or Dupont model, developed in 1920 by DuPont corp. DuPont analysis is a useful technique to bifurcate and analyze different drivers of “Return on Equity” (ROE). The breaking down of ROE allows investors and management of the company to focus on key metrics of financial performance individually to identify the strengths and weaknesses of the business.
Return On Equity (ROE) = Net Income/Equity
We decompose the ROE into 3 separate ratios as follows:
ROE = Profit margin * Asset turnover ratio * Leverage
So we need to look into each ratio to get an overview of the financial performance of the business. So if we express the above ratios mathematically, we get the following representation :
*NI = Net Income
So if we look closely, we can notice that denominator of one ratio cancels out the numerator of the adjacent ratio, at last, leaving the same result.
It is the ratio between income after tax and revenue or sales. This ratio measures the amount of income generated on each rupee of sale. If the ratio is higher than the competitors or higher than the previous year, that means the company is growing and making more profits.
Profit margin = Net Income / Sales
Asset Turnover Ratio
It is the ratio between sales and total asset. It measures the efficiency of using an asset to generate sales. It shows the operating efficiency of a company as it measures how many times the sales figure is of the total asset figure. A higher ratio implies that the company is using its assets judiciously to generate sales and profit.
Asset turnover ratio = Sales / Total Asset
Equity Multiplier or Leverage
It is the ratio between sales and total equity. It measures the firm’s relative use of debt & equity to finance assets. A higher ratio implies that the firm has used more debt to finance its assets and lower ratio implies that the firm has used more equity to finance its assets. So there should be an optimum debt to equity ratio to reap the maximum benefits of the capital structure.
Equity Multiplier = Total Assets / Total Equity
So if we improve profit margin or asset turn over ratio than we are improving our operating efficiency. All shareholders will agree to it that it is a good thing.
However, if we increase our financial leverage (equity multiplier) we will boost our ROE (return on equity) but at the expense of taking more financial risk i.e we are taking more debt and increasing the chance of bankruptcy.
Whether the risk is good or bad largely depends on the individual investor.
In the above graph “Company A” has a low risk as well as a low return and “Company B” has a high risk as well as a high return.
Which company is better, it all depends on the investor’s risk preference.