# DuPont Analysis

DuPont analysis is a technique that cuts through the return on equity (ROE) measure to identify what exactly is generating a company's return, i.e. whether it is high profit margin, efficient use of assets to generate more sales and/or use of more debt in its capital structure.

Return on equity (ROE) measures net income earned by the company for its shareholders. It is calculated by diving net income by average shareholders' equity. We can play some mathematics tricks to decompose ROE to some very meaningful components.

## Formula

ROE = | Net Income |

Average Shareholders' Equity |

Let us multiply and divide the above equation with Sales and Average Total Assets

ROE = | Net Income | × | Sales | × | Average Total Assets |

Average Shareholders' Equity | Sales | Average Total Assets |

After little tweaking we get the following:

ROE = | Net Income | × | Sales | × | Average Total Assets |

Sales | Average Total Assets | Average Shareholders' Equity |

It looks familiar, doesn't it? Net income divided by sales is the formula for net profit margin, sales divided by average total assets is the formula for total assets turnover ratio and average total assets divided by average shareholders' equity is the formula for financial leverage ratio (also called equity multiplier). This means we can rewrite the above equation as follows:

ROE = Net Profit Margin × Total Assets Turnover Ratio × Financial Leverage Ratio

It means that a company can have a high ROE if it has high net profit margin, high total assets turnover ratio and/or high financial leverage.

## Analysis

So, what do we get from all this effort? It helps us identify the sources of a company's return. If a company has high net profit margin and high asset turnover ratio, it is great. However, it is quite possible that a company might have a high ROE due to very high profit margin but very average asset turnover ratio. DuPont analysis helps investors and even the management identify where the company has performed well and where they have room for improvement.

A little more tweaking helps us discovers another important relationship. If we multiply and divide the formula for ROE with only average total assets, we get:

ROE= | Net Income | × | Average Total Assets |

Average Total Assets | Average Shareholders' Equity |

This shows that ROE = Return on Assets (ROA) × Financial Leverage Ratio

It means that a company can earn high return on equity by earning high return on its assets and/or using more debt in its capital structure. This decomposition helps identify whether a company's high ROE is a result of a company's more use of debt which is riskier.

Even further manipulation shows that

ROE = EBIT Margin × Interest Burden × Tax Burden × Asset Turnover × Financial Leverage

It means that a company can have high ROE if it has high operating margin, lower interest, lower income tax, efficient use of assets (more dollars of revenue per dollar of asset) and/or high use of debt in its capital structure.

## Example

Julie, Inc. and Joseph, Inc. are two companies in shoe-making business owned by JJ, Inc. They manufacture and market shoes for women and men respectively.

In the annual meeting held to review the companies' performance, the board was told that both the companies have earned a return on equity of 15%.

One of the directors has a management consultancy industry background, he has worked out the following breakup:

Julie | Joseph | |

Return on equity | 15% | 15% |

Net profit margin | 7.5% | 10% |

Total assets turnover | 2 | 1 |

Financial leverage ratio | 1 | 1.5 |

Although both the companies have a return on equity of 15%, their underlying strengths and weaknesses are quite opposite. While Joseph, Inc. has higher net profit margin, its ability to use its assets to generate sales is average. However, it has made up for it by higher use of debt in its capital structure.

The director suggests that board should carry out a detailed profitability and market positioning study of Julie, Inc. to improve its profit margin while the management of Joseph, Inc. is asked to come up with means to improve its use of assets either by divesting from redundant assets or making efforts to increase its sales. The company's financial analyst is asked to review the capital structure of both companies to identify whether Julie, Inc. should be using more debt.

Written by Obaidullah Jan, ACA, CFA and last revised on