The DuPont analysis breaks down return on equity (ROE) into three components: net profit margin, total asset turnover, and financial leverage. This allows companies to identify which specific factors are driving ROE and how they can be improved. The analysis provides a more comprehensive understanding of a company's profitability and valuation than looking at ROE alone. It is useful for comparing competitors and determining whether high ROE is due to sustainable or risky factors.

1. DuPont Analysis
Date: 27th June 2019

2. The Return on Equity ratio represents the amount of profit generated against the amount of
money invested by the shareholders.
But, mere ROE is not sufficient enough to convey the exact position of a company’s profitability,
because there may be many different factors (internal or external) affecting the profits of the
business.
To make this assessment a little more convenient, DuPont Analysis helps break down ROE into three
further components to identify the weight of each particular factor. As per the model, it is broken
down into three components i.e. Net Profit Margin, Total Asset Turnover and Financial Leverage
(Equity Multiplier).
Introduction

3. Components of the DuPont Equation
Profit Margin
As the name suggests,
profit margin indicates
profitability. It is a
measurement of how
well a business
strategizes its prices and
how lower it can drive its
costs. As an aspect of the
DuPont model, if the
profit margin of a
company increases, each
successive sale will bring
in more cash flow to the
company, ultimately
leading to a higher
overall return on equity.
Asset Turnover
Asset turnover is a
financial ratio that
measures how
efficiently a business’s
assets are used to
contribute towards
sales. Companies with
poor profits tend to
have a huge asset
turnover because more
and more assets are
being contributed
towards the increasing
sales of the company.
Financial
Leverage
Financial leverage (or
Equity Multiplier) refers
to the ratio of outside
debt that a company
needs to use to fund its
everyday operations in
relation to the equity
capital being utilized for
the same. Since dividend
payments do not come
under tax obligations, a
high volume of debt in
the company’s capital
structure leads to better
overall profitability.

4. The DuPont model is of great importance because it doesn't just want to know what return on
equity is, rather it allows you to identify which specific variables are causing the ROE in the first
place.
By measuring and highlighting those underlying realities, it becomes easier to analyze &
improve them (if required) and take better decisions.
Relevance of components
If you look closely at the formula, the net effect will still be net income against total equity. The
extension gives us a better understanding as to which factor weighs more in contributing towards
higher return on equity.

5. Example
Ratio ABC XYZ
Profit Margin 50% 35%
Total Asset Turnover .30 3.0
Financial Leverage 3.5 .50
Return on Equity 0.5*.3*3.5 = .525 =0.35*3*.5 = .525
As we can see, both ABC and XYZ (that operate in the same industry) have the same ROE.
But the weightage of different components varies, as explained below:
• ABC has better profit margin which indicates that its cost of goods is relatively lower
than that of XYZ.
– Sales with lower costs lead to higher profits which can be seen in the case of ABC

6. • On the other hand, XYZ has humongous amount of sales which can be witnessed by a huge asset
turnover
– Profit margins might be small, but XYZ is turning over a large quantity of goods
• When it comes to financial leverage, ABC is way ahead of XYZ by 7 times showing that the company
is heavily dependent on outside debt to fund its operations
– This might increase the ROE, but high leverage has equally negative impact on the overall position of the
business
The first two components ascertain the operations of the business. Higher these components, more will
be the operating profits of the business. However, one must also take care of the type of industry in
which the company operates as Net Profit Margin and Total Asset Turnover tend to swap each other at
times.
Analysis
MACHINERY COMPANY
• Poor turnover of assets and require
extensive capital investments
• Rely on a high profit margin to cover up for
the low turnover.
QUICK-SERVICE RESTAURANT CHAIN
• High asset turnover but much smaller
profit margin due to competitive prices in a
shark-filled industry.

7. A five-step DuPont model isolates operations and financial impacts on ROE, where we try
to see the effect of interest expense on the Net Profit Margin.
Both the three-and five-step equations, give a better understanding by analysing all factors
separately rather than just looking at a simple ratio.
For example, when looking at two competitors, one may have a lower ROE. With the five-
step analysis, one can see the reason behind it which may or not be: lenders see the
company as riskier and charge it higher interest or the company is not properly managed
and has a low equity multiplier or the company has higher COGS that lead to a poor profit
margin.
Identifying the core issue leads to a more comprehensive understanding of a company’s
valuations, leading to a better investment decision.
5-step DuPont Model

8. Conclusion
If there is an increase in the Net
Profit Margin without a change in
the Financial Leverage, it indicates
that the profits of the company are
increasing organically. But if the
Financial Leverage is the sole
reason behind a high ROE, it’s risky
because the company is focused
on utilizing its debt and that’s an
alarming sign.
Thus, we need to check whether
the growth in company’s
profitability is due to increase in
Net Profit Margin or Asset
Turnover Ratio (which is a good
sign) or only due to Financial
Leverage (which is bad news).

9. Disclaimer
Prepared By:
Research Intern [Sagnik Monga, BBA (Financial Investment Analysis)]
Phone Number: 0120-4550300
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