2017-04-26 17:35:31 Finance and Accounting English Learn about DuPont analysis and how it can be used to analyze return on equity in greater detail, and review an example calculation. https://d1bkf7psx818ah.cloudfront.net/wp-content/uploads/2017/04/08214417/Business-Owners-Can-Use-Dupont-Analysis-To-Analyze-Return-On-Equity.jpg Using Dupont Analysis to Analyze Return on Equity

Using Dupont Analysis to Analyze Return on Equity

DuPont analysis, also known as the DuPont identity or the DuPont model, is a method of breaking down a company’s return on equity into three parts so management can have a better understanding of its value. The model breaks down return on equity in such a way that management can focus on various aspects of the company’s operations to increase its value over time, without simply focusing on net income.

Basic Return on Equity

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

Return on equity = net income / shareholders’ equity

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

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

Though this number is helpful in analyzing the company, the DuPont method shows a much more detailed picture.

The DuPont Formula

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

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:

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 much stronger profit margin but is not utilizing its assets as well as Company B. Also, it is much less leveraged than Company B.

References & Resources

Information may be abridged and therefore incomplete. This document/information does not constitute, and should not be considered a substitute for, legal or financial advice. Each financial situation is different, the advice provided is intended to be general. Please contact your financial or legal advisors for information specific to your situation.
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