Analysis of a company is the basic requirement for every investor and creditor of the company to ensure that their investment is worthwhile and the risk is manageable as well as in line with their expectations. There are a number of models and tools used to analyze the value of the stock and determine its true value to understand if the stock is overpriced or underpriced. DuPont analysis is one of the many models of analyzing a company.
Given below is the meaning of DuPont Analysis and related details of the same.
What is DuPont analysis?
DuPont analysis is a model developed by DuPont Corporation in the year 1920 to analyze the return on equity. It is a deviation from the basic formula to evaluate return on equity (ROE) and provides a detailed picture to the analysts. This analysis is used to break the basic ROE model into three separate parameters or ROE generators to have a better understanding of the financial position and operations of the company. It, therefore, helps the management focus on their weakness or the area draining the ROE and take suitable measures to improve it.
What is the formula for DuPont analysis?
As mentioned above, the DuPont analysis breaks down the basic ROE formula into three components for refined understanding. The formula or the equation used in DuPont analysis is mentioned below.
|ROE as per DuPont analysis = Net profit margin x Total asset turnover x Equity multiplier|
The above equation can be further broken down as below.
ROE as per DuPont analysis = Net Income Sales Total Assets —————– x ————– x ——————- Sales Total Assets Common Equity
In the above equation, the first two components refer to the operational side of the business and the profitability which depends on the turnover and the profit generated by the company on such turnover. The final component of this equation is used to assess the risk of the business.
What are the components of DuPont Analysis?
There are three basic components that drive the ROE of any company. Let us discuss these components in detail hereunder.
Net Profit Margin
The profitability of any company is often the first point of reference for the investors and the creditors to analyze the company and its growth model. It is the net profit earned by the company after deducting all the expenses. The profit margin of the company is the basic comparison of the profit made out of the total turnover or the sales of the company. The formula for calculating the net profit margin is mentioned below.
Net profit margin = Net Profit / total sales of the company
Total asset turnover
The total asset turnover is used to measure the efficiency with which the company uses its assets and allocates its resources. It is the basic comparison between the total sales or the revenue of the company with its total assets. A higher total asset turnover ratio will tell the financial analysts that the company is successful in employing its assets in creating more sales. This will in turn show a positive impact on the overall ROE of the company. The formula for calculating the ROE is mentioned below.
Total assets turnover = Total sales (or Revenue) / Total assets
The third component of the DuPont analysis is the measure of the financial leverage of the company. It is used to assess if the company is using optimum debt to back its operations and any excess debt is not pumped in that can lower the equity multiplier. This component will tell the financial analysts if the company is not using additional debt to boost its ROE and gives a true and fair picture. The formula for equity multiplier is,
Equity Multiplier = Total assets / Common Equity
Understanding DuPont analysis with an example
DuPont analysis can be understood better by using the following example.
Given below is the data of two companies in the same industry and an analysis of the ROE based on DuPont analysis.
|Data||Company A||Company B|
|Net profit||Rs. 10,000||Rs. 5,000|
|Sales / Revenue||Rs. 50,000||Rs. 25,000|
|Total assets||Rs. 25,000||Rs. 50,000|
|Equity||Rs. 20,000||Rs. 20,000|
From the above data, we can calculate the separate components of ROE and the final ROE of the companies.
|Ratios||Company A||Company B|
|Net Profit||10000/50000 = 0.2||5000/25000 = 0.2|
|Total assets turnover||50000/25000 = 2||25000/50000 = 0.5|
|Equity multiplier||25000/20000 = 1.25||50000/20000 = 2.5|
|ROE||0.2 * 2* 1.25 = 0.5||0.2 * 0.5 * 2.5 = 0.25|
From the above detailed analysis of the ROE, investors can understand that although both the companies have the same net profit margin, the ROE of Company A is higher on account of higher total assets turnover despite the fact that Company B has a higher equity multiplier. Hence, investors will prefer to invest in Company A as compared to Company B based on the DuPont analysis of both companies.
Why is DuPont analysis better than simple ROE analysis?
A simple ROE formula is calculated as the ratio between the net profit of the company and the total equity. This ratio will give the shareholders the net return on their investment however, it will not help the management of the company understand and analyze the various areas that need improvement to improve the overall ROE of the company. By breaking down the simple ROE formula as per the DuPont model, the management and the investors can make a detailed analysis of the company affairs as well as focus on improving their profit margin as per the industry standards or their asset turnover ratio. It will also tell them if the company is using excess debt to boost the ROE which can, in turn, pose a risk of solvency or liquidity issues if the company is not able to meet its debt obligations.
What are the limitations of DuPont analysis?
Like any other mode of analysis, DuPont analysis is also not fool proof and has its own set of limitations. The basic limitation of this mode of analysis is that the data needed for such a model is based on information from the company. Hence, there is always a chance that the data is manipulated and thus the analysis will not provide a true picture of the company position. The other drawback of DuPont analysis is that this model can be used for comparison only between two or more companies from the same industry. A comparison across the industries will again not provide the correct analysis of the company position and may mislead the investors or creditors.
DuPont analysis is one of the many tools that can be used by the companies to ascertain their return on equity and assure the interested parties like the shareholders, investors, and creditors that their investment is in good hands and the management is employing best efforts to maximize their wealth. It can also be used to weed out the shortcomings and reach the optimum level of profitability.
For companies having zero debt, the equity multiplier can be taken as 1 and the rest of the components can be calculated as usual. Thus DuPont analysis can also be used to analyze the ROE of zero debt companies.
No. A high debt level can indicate possible solvency and liquidity issues if the company is not able to meet its obligations in the short term (interest on debt) or long term (redemption of debt).
The ideal asset turnover and profitability ratio for any industry is different based on how capital intensive it is. For example, a manufacturing or heavy machinery industry may have a higher profit margin but the asset turnover ratio may be low. On the other hand, in an FMCG industry, the asset turnover may be high but the profit margins are usually not too high on account of many factors like higher competition, government price caps, etc.
A company can increase its ROE by either increasing its profit margin, optimizing the usage of its assets, or by increasing its financial leverage. However, it is to be noted an increase in the ROE due to the first two factors is considered to be healthy for the company. On the other hand, an increase in ROE solely due to an increase in its financial leverage can be considered as a potential red flag and will require further analysis of its financial position.