accounting

What is the DuPont Analysis?

The DuPont Analysis offers a way to break down your company’s return on equity and better understand the driving forces behind its profitability. It also helps identify areas that enhance the value of your company’s return on equity. Derived from the DuPont Corporation in the 1920s, this method provides valuable insights into your company’s financial health and potential growth. The formula also comes in handy for potential investors evaluating your company ahead of purchasing stock or an equity stake in your business.

The DuPont Analysis Formula

A DuPont Analysis contains three main components, and the final return on equity comes out as a percentage. The first two components — net profit margin and total asset turnover — assess your business’ operations. The net profit margin shows you the portion of revenue that comprises profit, while the total asset turnover measures how efficiently your company turns assets into sales. The third component — equity multiplier — shows your company’s financial leverage, or the risk level of investing in your business.

The DuPont Analysis formula looks like:

Net profit margin x total asset turnover x equity multiplier = return on equity.

This formula further breaks down the components like: (net income / sales) x (sales / total assets) x (total assets / average shareholder equity) = return on equity.

Example of the DuPont Analysis

Let’s say your company has a net income of \$100,000 with \$50,000 in sales and total assets of \$500,000. Further, your company has an average shareholder equity of \$250,000. To calculate your return on equity, you first figure your net profit margin by dividing \$100,000 in net income by \$50,000 in sales for a total of 2, or 20%. Next, you figure your asset turnover by dividing \$50,000 in sales by total assets of \$500,000 for a total of 0.1.

Then, you figure your equity multiplier by dividing your total assets of \$500,000 by average shareholder equity of \$250,000 for a total of 2. Finally, you multiply your totals together like 2 x 0.1 x 2 = 0.4, which means your company has a 40% return on equity. To recap:

• \$100,000 in net income / \$50,000 in sales = 2 profit margin
• \$50,000 in sales / \$500,000 in total assets = 0.1 asset turnover
• \$500,000 in total assets / \$250,000 average shareholder equity = 2 equity multiplier
• Profit margin of 2 x asset turnover of 0.1 x equity multiplier of 2 = 4, or a 40% return on equity

What the DuPont Analysis Measures

Once you determine your return on equity, you can identify how your business handles its profitability in relation to how it uses investors’ money and generates profits. Investors look for high returns on equity when looking for sure bets on what companies stand to make the most profits. A higher return on equity usually means a better investment for shareholders.

For example, a 12% return on equity means a company made 12 cents of profits on every dollar invested by shareholders. Or, to put it another way, one share of that company’s stock saw a 12% return.

How to Use DuPont Analysis to Analyze Return on Equity

Basic Return on Equity

The return on equity ratio is a profitability ratio that measures your company’s ability to generate profits from shareholders’ investment. This ratio is calculated as:

Return on equity = net income / shareholders’ equity.

For example, assume your company has net income of \$500,000 and shareholders’ equity of \$5 million. The return on equity is:

\$500,000 / \$5 million = 10%

Even though this number is helpful in analyzing your company’s return on equity, the DuPont method shows a much more detailed picture.

DuPont Analysis Formula

The DuPont analysis breaks return on equity into three major components:

• Operating efficiency as measured by profit margin
• Asset use efficiency as measured by total asset turnover
• Financial leverage as measured by the equity multiplier

These individual pieces are calculated as:

• Profit margin = net income / sales
• Total asset turnover = sales / assets
• Equity multiplier = assets / shareholders’ equity

Taken as a whole, the DuPont formula is:

Return on equity = profit margin x total asset turnover x equity multiplier

This breaks down into:

Return on equity = (net income / sales) x (sales / assets) x (assets / shareholders’ equity)

Example DuPont Calculations

Let’s say there are two companies. Over one year, both companies have a 45% return on equity. On the surface, both may seem very similar since they have equal return on equity ratios, but upon further analysis using the DuPont method, it is shown they are very different.

Assume the following data for Company A:

• Net income = \$90,000
• Sales = \$300,000
• Assets = \$600,000
• Equity= \$200,000

Assume the following data for Company B:

• Net income = \$22,500
• Sales = \$150,000
• Assets = \$25,000
• Equity = \$50,000

The calculations for the components of return on equity for Company A are:

• Profit margin = \$90,000 / \$300,000 = 30%
• Total asset turnover = \$300,000 / \$600,000 = 50%
• Equity multiplier = \$600,000 / \$200,000 = 3

The calculations for the components of return on equity for Company B are:

• Profit margin = \$22,500 / \$150,000 = 15%
• Total asset turnover = \$150,000 / \$25,000 = 600%
• Equity multiplier = \$25,000 / \$50,000 = 0.5

The DuPont analysis for each is:

Company A return on equity = 0.3 x 0.5 x 3 = 45%

Company B return on equity = 0.15 x 6 x 0.5 = 45%

It is very clear these companies are different. Company A has a much stronger profit margin but is not utilizing its assets as well as Company B. Also, Company A has less leverage than Company B. The DuPont analysis paints a much clearer picture and would give you much better data about your company’s performance.

Other DuPont Analysis Considerations

Some industries benefit from different parts of the DuPont Analysis formula. For example, a machinery manufacturer probably has low asset turnover but requires a lot of investments in equipment and facilities that last a long time. The machinery manufacturer also has higher prices and volume for the goods it produces.

Therefore, this type of firm typically has a higher profit margin versus a low turnover. Contrarily, a fast food restaurant may see a high asset turnover — due in part to high employee turnover rates — and a smaller profit margin because individual items sell at lower prices. The fast food restaurant makes up for the lower prices by having lots of volume.